THE  LIBRARY 

OF 

THE  UNIVERSITY 
OF  CALIFORNIA 

LOS  ANGELES 


SOUTHERN    BRAlMCn 

UNIVERSITY  OF  CALIFORNIA 
LIBRARY 

LOS  ANGELES,  CALIF. 


Graduate 

4,  California 


Public  Accounting 
and  Auditing 


Correlating  the  subjects,  Accounting — Theory  and 

Practice,  Auditing — Theory  and  Practice,  and 

Commercial    Law,    thereby    enabling    the 

student  to  obtain  a  view  of  each  of 

these  subjects  in  its  relation   to 

the    problems    of    the    Public 

Accountant  and  Auditor 


By 

J.  F.  SHERWOOD 

Certified  Public  Accountant  and  Auditor 

vv\  ^    J-  I 


Published  by 

SOUTH-WESTERN  PUBLISHING  CO. 
Cincinnati,  Ohio 


Copyright  1920 

SOUTH-WESTERN  PUBLISHING  CO. 
Cincinnati,  Ohio 


Bus.  Admin. 
Library 

HF 
5667 

S55p 
v.I 


PREFACE 


Accountancy  is  generally  considered  the  youngest  of  the 
professions.  In  1896,  New  York  enacted  the  first  Certified 
Public  Accountant  law  in  this  country,  and  thus  formally  recog- 
^  nized  accountancy  as  a  profession.  Since  that  time,  all  the 
T  states  excepting  two  have  enacted  similar  laws,  until  account- 
*•  ancy  is  now  recognized  as  one  of  the  leading  professions.  Almost 
imperceptibly  accounting  and  auditing  have  grown  to  be  indis- 
pensable factors  in  the  policy  of  every  business  enterprise. 
Today,  it  is  estimated  that  there  are  approximately  three  thou- 
sand Certified  Public  Accountants  in  the  United  States.  There 
are  hundreds  of  firms  of  accountants  employing  junior  and 
senior  accountants,  and  these  firms  are  now  looking  to  the 
schools  of  commerce  for  suitable  recruits  for  their  staffs. 

Harold  Benington,  C.  P.  A.,  President  of  the  Illinois  Society 
of  Certified  Public  Accountants,  in  an  address  delivered  in 
Chicago,  December,  1915,  at  a  convention  of  the  National 
Commercial  Teachers'  Federation,  said: 

"We,  the  public  accountants,  have  to  rely  to  a  very  large 
extent  upon  you  gentlemen  for  the  recruits  that  enlist  for  ser- 
vices in  our  offices.  We  rely  upon  you  to  send  us  men  who  have 
undergone  the  preliminary  training  and  are  ready  for  active 
service.  We  don't  expect  you  to  send  us  veterans,  but  we  do 
expect  men  who  studied  the  rudimentary  theory  of  tactics  and 
know  how  to  handle  their  tools. 

"It  seems  to  me  that  your  share  of  the  work  lies  in  con- 
stantly improving  and  expanding  the  character  of  the  instruc- 
tion which  you  offer  to  your  students,  and  that  our  share  of 
the  work  lies  to  a  very  large  extent  in  encouraging  young  men 
who  have  just  begun  business,  or  who  are  just  about  to  enter 
it,  to  take  your  courses  of  instruction,  making  them  realize 
that  their  immediate  earning  capacity  is  going  to  be  increased." 

Robert  Montgomery,  Ex-President  of  the  American  Asso- 
ciation of  Public  Accountants,  now  a  member  of  the  Executive 
Committee  of  the  American  Institute  of  Accountants,  said 
in  a  recent  address : 

"Something  must  be  done  at  once  to  increase  the  number 
of  accountants.  Already  the  amount  of  work  devolving  upon 
the  reputable  accountants  of  the  country  is  considerably  in 
excess  of  their  normal  capacity.  The  present  difficulties  will 
be  enormously  enhanced  unless  we  can  secure  from  our  insti- 
tutions of  learning,  a  vastly  greater  number  of  qualified  ac- 
countants." 

The  leading  institutions  of  education,  both  public  and 
private,  are  now  offering  instruction  in  accounting.  This  text 
is  designed  for  use  in  those  schools  that  desire  to  train 


students  to  become  junior  accountants  associated  with  firms 
of  public  accountants  and  auditors,  students  who  are  looking 
forward  to  the  time  when  they  can  qualify  for  promotion  to 
positions  as  senior  accountants,  and  be  prepared  for  the  pro- 
fessional examinations  for  the  degree  "C.  P.  A." 

Accounting,  theory  and  practice,  Auditing  and  Commer- 
cial Law  are  considered  basic  subjects  in  courses  of  this  nature. 
There  is  a  distinction  between  Accounting  and.  Auditing.  How- 
ever, the  term  Accounting  comprehends  audits,  among  other 
things,  and  Auditing  presupposes  a  knowledge  of  accounting. 
Commercial  Law  is  not  developed  herein  as  a  distinct  subject, 
but  rather  it  is  intended  to  show  its  contact  with  Accounting. 

In  preparing  this  treatise,  we  have,  therefore,  correlated 
these  subjects  so  that  the  student  obtains  a  view  of  each  in  its 
relation  to  the  problems  of  the  public  accountant  and  auditor. 
As  the  subject  matter  is  developed,  the  student  learns  the  rela- 
tion of  Accounting  and  Auditing  and  perceives  the  contact  of 
Commercial  Law  with  Accounting. 

A  knowledge  of  the  principles  of  bookkeeping  and  elemen- 
tary accounting  and  of  Commercial  Law  is  a  prerequisite  to 
satisfactorily  comprehending  the  principles  of.  Public  Account- 
ing and  Auditing. 

The  author  desires  to  take  this  opportunity  to  express 
his  appreciation  of  the  help  and  inspiration  received  from  those 
instructors,  professional  accountants  and  others,  who  have 
given  material  assistance  in  compiling  the  manuscript  and  in 
reading  the  proof. 

J.  F.  SHERWOOD,  C.  P.  A. 
Cincinnati,  Ohio. 
July  i,  1920. 


CONTENTS 


Pages 
CHAPTER  1 5-16 

The  Work  of  the  Junior 

The  Work  of  the  Senior 

Purposes  and  Advantages  of  an  Audit 

Qualifications  of  an  Auditor 

Responsibility  of  Auditors 

Theory  of  Accounts 

Accounting  Systems 

Single  Entry  Bookkeeping 

Double  Entry  Bookkeeping 
Commercial  Law 

Contact  with  Accounting 

Subdivisions  of  Law 

CHAPTER  II 17-32 

Beginning"  an  Audit 
Nature  of  Engagement 
The  Value  of  an  Audit 
Kinds  of  Audits 

Internal  Audit 

Cash  Audit 

Balance  Sheet  Audit 

Detailed  Audit 
Classification  of  Accounts 

Real  Accounts 

Nominal  Accounts 
The  Law  of  Contracts 

Essential  Conditions 

CHAPTER  III 33-48 

Books  of  Account 

Books  of  Original  Entry 

Books  of  Final  Entry 
The  Trial  Balance 
The  Balance  Sheet 
The  Law  of  Contracts  (Continued) 

Validity  of  Contracts 


2  CONTENTS 

Pages 
CHAPTER  IV 49-64 

(Beginning  a  Balance  Sheet  Audit) 
Cash 

1.  Accounting  Theory 

The  Theory  of  the  Cash  Account 

Imprest  System 

Fraud 

2.  Auditing  Theory 

Counting  the  Cash 
Verifying  the  Bank  Balance 
Reconciling  the  Bank  Certificate 

3.  Auditing  Procedure 

Bank  Certificate 

Working  Papers 

The  Law  of  Contracts  (Continued) 
Assignment  of  Contracts 
Novation 
Discharge  of  Contracts 

CHAPTER  V 65-80 

Notes  Receivable 

1.  Accounting  Theory 

Terminology 

Notes  Receivable  Discounted 

Contingent  Liabilities 

2.  Auditing  Theory 

Listing  the  Notes  Receivable 

3.  Auditing  Procedure 

Working  Papers 
Securities 

1.  Accounting  Theory 

Speculative  Investments 
Non-speculative  Investments 
Sinking  Fund  Investments 

2.  Auditing  Theory 

Listing  of  Securities 

3.  Auditing  Procedure 

The  Law  of  Negotiable  Instruments 
Essentials  of  Negotiability 
Non-essentials  of  Negotiability 

CHAPTER  VI 81-96 

Accounts  Receivable 

i.  Accounting  Theory 
The  Sales  Ledger 
Discounts 
Doubtful  Accounts 


CONTENTS  3 

Pages 

2.  Auditing  Theory 

Aging  Accounts 
Verification  of  Accounts 

3.  Auditing  Procedure 

4.  Income  Tax  Procedure 

5.  Legal  Phases 

The  Uniform  Sales  Act 

CHAPTER  VII 97-112 

Inventories 

1.  Accounting  Theory 

Book  Inventories 
Physical  Inventories 
Turnover 

2.  Auditing  Theory 

3.  Auditing  Procedure 

4.  Income  Tax  Procedure 

CHAPTER  VIII 113-128 

The  Trial  Balance 
Items  not  on  Trial  Balances 
Reading  the  Minutes 
Fixed  Assets 

The  Land  Account 

The  Buildings  Account 
The  Law  of  Real  Estate 
Income  Tax  Procedure 

CHAPTER  IX 129-144 

Fixed  Assets  (Continued) 

Capital  and  Revenue  Expenditures 

The  Machinery  Account 

The  Tools  and  Implements  Account j 

The  Account  with  Horses,  Wagons  and 
Harness 

The  Office  Furniture  Account 
Auditing  Theory 
Auditing  Procedure 
The  Law  of  Personal  Property 

CHAPTER  X 145-160 

Depreciation 

Causes  of  Depreciation 

Factors  Bearing  on  Amount  of  Depreciation 

Methods  for  Calculation 

Accounting  Procedure 
The  Law  of  Contracts  (Reviewed) 


4  CONTENTS 

Pages 

CHAPTER  XI. . . . . 161-176 

Current  Liabilities 

Accounts  Payable 

Notes  Payable 
Contingent  Liabilities 
Accrued  Liabilities 
Legal  Phases 

What  Constitutes  Negotiation 

Endorsement 

CHAPTER  XII 177-192 

Fixed  Liabilities 
Mortgages 
Bonds 

CHAPTER  XIII 193-208 

Net  Worth 

The  Sole  Proprietorship 
The  Copartnership 
The  Corporation 

Stock  of  No  Par  Value 

Classification  of  Capital  Stock 

Pro-iorma  Opening  Entries 

CHAPTER  XIV 200-224 

Profit  and  Loss 

The  Profit  and  Loss  Statement 

How  to  End  an  Audit 

The  Auditor's  Working  Sheet 

CHAPTER  XV 225-240 

The  Report 

The  Statements 
The  Comments 
The  Certificate 

(Concluding  a  Balance  Sheet  Audit) 

APPENDIX 241-256 

Accounting  Terminology 


Chapter  One 

Accounting  firms  usually  classify  their  employees  as 
JUNIORS  and  SENIORS.  In  large  firms  there  may  be  several 
different  STAFFS  located  in  different  cities.  A  staff  will  be 
under  the  supervision  of  a  SUPERVISING  or  MANAGING 
SENIOR  and  he  in  turn  may  be  under  the  direction  of  a  PART- 
NER of  the  firm. 

THE  WORK  OF  THE  JUNIOR 

At  first  a  junior  will  usually  be  assigned  to  work  under 
the  direct  supervision  of  a  senior  who  is  familiar  with  the  dif- 
ferent phases  of  the  field  work  and  he  will  be  instructed  as  to 
just  what  to  do  and  how  to  go  about  it.  In  due  time,  however, 
he  will  be  sent  out  only  with  general  instructions  from  the 
senior  who  may  not  accompany  him  and  he  will  be  expected  to 
know  how  to  proceed  with  the  work. 

Policies  of  the  firm  must  be  thoroughly  understood.  They 
will  vary  but  every  firm  has  certain  policies  that  it  expects  all 
employees  to  adhere  to  closely.  Juniors,  seniors,  the  managing 
senior,  and  even  a  partner  will  be  required  by  all  firms  to  pre- 
pare and  keep  a  set  of  WORKING  PAPERS  showing  a  complete 
record  of  work  completed.  The  arrangement  and  scope  of  these 
working  papers  will  naturally  vary.  They  will  be  made  up  of 
SCHEDULES  containing  records  and  figures  arranged  in  a 
systematic  order  so  as  to  show  conclusions;  how  the  conclusions 
were  arrived  at;  why,  in  some  cases,  the  figures  differ  from  the 
book  figures:  and  to  show  items  not  appearing  in  the  books  of 
account  at  all. 

Briefly  the  duties  of  the  junior  will  be  the  verification  of 
bank  and  cash  balances,  checking  footings,  checking  and  test- 
ing postings,  vouching  entries,  verifications  of  securities,  taking 
Trial  Balances,  checking  inventories,  making  schedules  and  a 
variety  of  similar  work. 

In  accounting  terms  the  work  to  be  performed  is  referred 
to  as  an  ENGAGEMENT  and  the  party  for  whom  it  is  to  be 
done  is  spoken  of  as  a  CLIENT. 

In  undertaking  an  engagement  it  is  essential  to  keep  in 
mind  the  work  to  be  performed  whether  an  AUDIT,  an  EX- 
AMINATION or  an  INVESTIGATION;  and  if  an  audit, 
whether  it  is  to  be  a  BALANCE  SHEET  AUDIT  or  a  DE- 
TAILED AUDIT.  A  Balance  Sheet  audit  is  frequently  referred 
to  as  a  PARTIAL  AUDIT. 


6  PUBLIC  ACCOUNTING  AND  AUDITING 

THE  WORK  OF  THE  SENIOR 

Naturally  the  senior  has  certain  responsibilities  that  do 
not  fall  on  the  junior.  He  may  have  one  or  several  juniors 
under  his  supervision  depending  upon  the  nature  and  extent 
of  each  engagement.  He  will  be  expected  to  plan  and  direct 
their  work,  decide  difficult  and  complex  questions  arising  from 
time  to  time,  and  make  a  complete  report  of  each  engagement 
completed,  submitting  all  necessary  working  papers  arranged  to 
show  in  detail  the  work  performed.  As  a  rule  he  will  not  be 
expected  to  prepare  final  reports  for  the  client,  this  being  done 
in  the  office  at  the  direction  of  a  supervising  senior  or  a  partner 
of  the  firm.  However,  the  senior  who  expects  to  become  a 
manager  or  a  partner  of  the  firm  should  learn  to  prepare  cer- 
tificates and  "reports  from  a  set  of  working  papers. 

PURPOSES  AND  ADVANTAGES  OF  AN  AUDIT 

Minor  Objects.  The  minor  objects  of  an  audit  may  be 
classified  under  two  distinct  heads. 

(a)  Detection  and  prevention  of  Fraud. 

(b)  Detection  and  prevention  of  Errors. 

Fraud.  In  the  beginning  of  professional  auditing,  fraud 
was  considered  the  principal  objective  and  an  auditor  was  em- 
ployed only  when  fraud  was  suspected  by  the  management. 
Consequently  when  an  auditor  appeared  in  an  office  and  began 
his  investigation,  the  bookkeepers  began  to  wonder  who  was 
to  be  the  victim  and  in  most  cases  the  auditor  was  looked  upon 
as  a  sort  of  detective.  Today  fraud  is  considered  only  as  a 
minor  reason  and  not  a  principal  reason  for  an  audit, t  hough 
it  is  often  detected  by  the  auditor  regardless  of  what  may  be 
the  chief  reason  for  the  audit.  Either  a  continuous  audit  or 
a  periodical  audit  will  go  a  long  way  toward  the  prevention 
of  fraud  and  embezzlement. 

Errors.  From  the  standpoint  of  an  audit  there  are  certain 
different  classes  of  errors  and  the  auditor  should  be  able  to 
distinguish  between  them  without  any  difficulty.  Errors  may 
be  divided  into  five  general  classes  as  follows: 

Errors  of  Principle.  Errors  of  Omission. 

Errors  of  Commission.          Clerical  Errors. 
Offsetting  Errors. 

Errors  of  principle  and  commission  are  very  similar  and 
so  important  that  they  must  be  detected  by  the  auditor.  The 
most  common  errors  of  this  class  are  due  to  the  inability  of  the 
bookkeeper  to  distinguish  between  capital  and  revenue  expen- 
ditures. Frequently  items  are  charged  to  Expense  which  should 
be  charged  to  Property  accounts  and  vice  versa. 


PURPOSES  AND  ADVANTAGES  OF  AN  AUD  IT 

As  an  example  of  each  class  of  errors,  the  following  list  was 
compiled  from  actual  auditing  practice: 

Errors  of  Principle,  (a)  Sales  were  made  to  a  number 
of  customers  residing  in  Canada.  These  customers  would  remit 
by  check  and  the  checks  were  deposited  in  the  bank  but  the 
custom  of  the  bank  was  to  accept  checks  on  Canada  for  collec- 
tion only.  The  bookkeeper  entered  all  such  checks  as  cash  re- 
ceipts and  added  them  to  the  bank  balance  as  soon  as  deposited. 
One  of  these  checks  was  included  in  the  cash  balance  at  the  close 
of  the  fiscal  period. 

(b)  In  analyzing  the  account  with  Buildings,  it  was  dis- 
covered that  an  end  wall  of  a  concrete  building  had  partly  caved 
in.  The  cost  of  repairing  the  wall  was  $2,195.30  and  this  sum 
had  been  charged  to  the  Buildings  account  instead  of  to  Build- 
ing Expense  account. 

Errors  of  Commission,  (a)  On  the  credit  side  of  the 
Selling  Expense  account  an  item  of  $1.00  was  found  without  a 
posting  reference.  Inquiry  of  the  bookkeeper  revealed  that  at 
that  date  the  ledger  was  out  of  balance  that  sum  and  he  had 
made  the  entry  in  order  to  "force"  the  balance. 

(b)  An  invoice  for  $100.  was  paid  but  subsequently  included 
in  a  statement  rendered  and  paid  again  by  the  bookkeeper. 

Errors  of  Omission,  (a)  The  bookkeeper  failed  to  deduct 
discounts  from  a  number  of  invoices  although  they  were  paid  in 
the  discount  period  according  to  terms. 

(b)  Delivery  service  was  rendered  in  behalf  of  another 
company  but  not  billed  nor  collected. 

(c)  In  auditing  the  books  of  a  Hardware   Company  it 
was  found  that  a  plumber  had  rendered  service  amounting  to 
$45.40,  but  this  had  not  been  billed  nor  collected,  consequently 
did  not  appear  on  the  books  of  original  entry. 

Clerical  Errors,  (a)  Accounts  Payable  column  in  pur- 
chases journal  overfooted  $10.00. 

(b)  The  total  of  the  column  in  the  purchase  journal  known 
as  "General  Expense"  for  June  was  posted  to  the  Postage  account. 

(c)  The  footing  of  the  sales  book  for  April,  $18,546.90, 
was  posted  as  $18,564.90.     (This  is  known  as  a  transposition 
of  figures  and  is  a  very  common  error.) 

(d)  An    invoice  for  $4.97  was  entered  as  Postage  instead 
of  Stationery  and  Printing. 

Offsetting  Errors,  (a)  An  account  with  a  customer  in 
the  customers'  ledger  was  overfooted  $10.00  on  both  sides  and 
the  controlling  account  with  "Accounts  Receivable"  in  the 
general  ledger  showed  an  overfooting  on  both  sides  of  the  same 
amount. 

(b)  The  "Stationery  and  Printing"  column  in  purchases 
journal  was  underfooted  $1.00  while  the  "Advertising"  column 
was  overfooted  the  same  amount,  therefore,  the  total  of  the 
distribution  columns  agreed  with  the  "Total"  column. 


8  PUBLIC  ACCOUNTING  AND  AUDITING 

Major  Objects.     The  more  important  reasons  for  audits 
may  be  classified  as  follows : 

(a)  Determining  a  condition  of  affairs. 

(b)  An  audit  for  credit  purposes. 

(c)  An  adjustment  between  partners. 

(d)  An  audit  as  an  aid  in  the  adjustment  of  claim  on  ac- 
count of  fire  loss. 

(e)  As  an  aid  to  bonding. 

(f)  Protecting  stockholders  and  bondholders. 

(g)  To  facilitate  the  sale  of  a  business. 

(h)     As  a  basis  of  recovery  for  negligence  on  the  part  of  a 
previous  auditor. 

John  R.  Wildman,*  in  his  "Principles  of  Auditing,"  says 
with  regard  to  the  occasions  for  auditing: 

"Generally  speaking,  it  may  be  said  that  auditing 
is  done,  first,  to  satisfy  someone  as  to  the  correctness 
of  the  accounts ;  second,  to  prove  or  disprove  some  con- 
tention;   third,  to  influence  prospective  purchasers  of- 
goods  or  proprietary  interests,  and  prospective  creditors. 

"While  the  occasions  for  auditing  are  numerous  and 
varied,  they  are  probably  all  comprehended  in  the  fol- 
lowing category: 

A.  AT  THE  INSTANCE  OF  SOMEONE  WITHIN  THE 

ORGANIZATION. 

1.  To  satisfy  someone  within. 

2.  To  satisfy  someone  without. 

3.  To  prove  or  disprove  some  contention  on  the 
part  of  someone  within. 

4.  To  prove  or  disprove  some  contention  on  the 
part  of  someone  without. 

5.  To  influence  someone  within. 

6.  To  influence  someone  without. 

B.  AT  THE  INSTANCE  OF  SOMEONE  WITH- 
OUT THE  ORGANIZATION. 

1 .  To  satisfy  someone  without. 

2.  To  prove  or  disprove  some  contention  on  the 
part  of  someone  without. 

3.  To  influence  someone  without." 

QUALIFICATIONS  OF  AN  AUDITOR 

A  brief  summary  of  the  necessary  qualifications  of  a  com- 
petent professional  auditor  would  include  at  least  the  following: 

*Professor  of  Accounting  at  New  York  University. 


RESPONSIBILITY  OF  AUDITORS  9 

(a)  A  thorough  knowledge  of  acccounting,  embracing  a 
complete  mastery  of  bookkeeping. 

(b)  Familiarity   with   all   the   systems   of   accounting   in 
general  use  and  with  the  various  details  of  office  and  factory 
methods. 

(c)  A  fair  knowledge  of  commercial  law. 

(d)  Absolute  honesty  including  a  natural  habit  of  fair 
dealing  and  the  faculty  of  inspiring  others  to  trust  in  his  integrity. 

(e)  An  extensive  preliminary  education  and  the  broadest 
kind  of  business  training. 

(f)  Analytical  ability  and  the  ability  to  grasp  situations 
quickly. 

(g)  Ability  to  meet  people  and  converse  easily,  and  with 
dignity.     BE  A  GENTLEMAN    IN    EVERY    SENSE    OF 
THE   WORD. 


Anyone  who  holds  himself  out  to  be  skilful  in  any  trade  or 
profession,  and  who  is  negligent  in  the  performance  of  an  under- 
taking and  does  not  use  the  skill  of  an  ordinarily  skilful  trades- 
man or  professional  man,  becomes  legally  responsible  and  is 
subject  to  a  suit  and  penalty  for  damages  for  such  failure.  This 
statement  applies  to  an  accountant  or  an  auditor.  His  moral 
responsibility  is  undoubtedly  higher  than  his  legal  responsi- 
bility. Legally,  one  is  not  required  to  measure  up  to  the  stan- 
dard of  the  most  skilful  but  only  to  the  standard  of  an  ordinarily 
skilful  accountant  and  auditor.  Morally,  an  auditor  is  respon- 
sible if  he  does  not  properly  perform  his  duties  in  a  manner 
which  shall  conform  to  the  best  practices  of  the  profession. 


THEORY  OF  ACCOUNTS 

"Accountancy  comprehends  the  conduct  of  audits, 
examinations  and  investigations;  devising  and  install- 
ing systems;  criticising  organizations  and  management; 
and,  in  some  cases  efficiency  work." — New  York  State 
Educational  Dept.  Syllabus. 

ACCOUNTANCY  is  a  profession  having  to  do  with  the 
recording,  verification  and  presentation  of  facts,  involving  the 
acquisition,  production,  conservation  and  transfer  of  values. 

ACCOUNTING  is  the  science  which  treats  of  the  syste- 
matic record,  compilation  and  presentation  in  a  comprehensive 
manner  of  the  financial  operations  of  a  business. 


io  PUBLIC  ACCOUNTING  AND  AUDITING 

ACCOUNTING  SYSTEMS 

Generally  speaking  there  are  but  two  different  systems  of 
bookkeeping  and  accounting— SINGLE  ENTRY  and  DOUBLE 
ENTRY.  It  is  doubtful,  however,  if  single  entry  bookkeeping 
may  be  correctly  called  a  system.  It  would  rather  seem  to 
represent  a  lack  of  system. 

A  knowledge  of  the  so-called  single  entry  method  of  keeping 
books  is  necessary  for  there  is  nothing  more  common  in  the  work 
of  the  accountant  than  to  be  called  upon  to  change  a  single 
entry  system  to  double  entry.  The  great  number  of  questions 
in  CERTIFIED  PUBLIC  ACCOUNTANT  examinations  based 
upon  this  changing  process  is  but  evidence  of  the  necessity  of 
a  thorough  understanding  of  the  proper  method  of  procedure. 

The  accountant  will  need  to  know  the  advantages  and  dis- 
advantages of  single  and  double  entry  bookkeeping;  the  method 
of  ascertaining  profits  and  losses;  how  to  prepare  financial  state- 
ments; and  the  course  to  pursue  in  the  conversion  of  single  to 
double  entry  bookkeeping. 

SINGLE  ENTRY  BOOKKEEPING 

1.  The  purpose  of  single  entry  bookkeeping  is  to  keep  a 
record  of  transactions  with  persons  only,  that  is,  with  customers, 
creditors,  and  the  proprietor.    However,  accounts  are  frequently 
kept  with  cash,  merchandise,  and  a  few  other  items  of  special 
interest  to  the  firm. 

2.  The  disadvantages  of  the  system  are: 

(a)  Nominal  accounts  are  not  kept,  therefore,  profits  and 
losses  are  not  shown. 

(b)  A  Trial   Balance  cannot  be  taken  unless  the  auditor 
goes  over  the  journal  or  day  book  and  sets  up  accounts  and  posts 
all  entries  or  arranges  them  in  columns  on  a  working  sheet. 

(c)  Errors   which   creep   into   the   records   are   not   easily 
detected. 

(d)  A  Balance  Sheet  can  be  made  up  only  by  an  inventory 
of  the  assets  and  liabilities. 

(e)  It  does  not  provide  for  the  determination  of  cost  of 
operation  of  different  departments  nor  for  departmental  returns. 

3.  To  prepare  a  Profit  and  Loss  statement  from  a  single 
entry  set  of  books,  subtract  from  the  net  worth  at  the  end 
of  the  period  the  net  worth  at  the  beginning.    To  this  amount 
add  amounts  withdrawn  from  investment  and  subtract  addi- 
tional investments.     The  result  will  either  indicate  a  profit  or 
a  loss. 


ACCOUNTING  SYSTEMS  11 

4.  To  prepare  a  Balance  Sheet  from  a  single  entry  set  of 
books,  it  is  necessary  to  take  an  inventory  of  all  assets  and 
liabilities  or  to  add  to,  or  deduct  from,  the  assets  and  liabil- 
ities as  at  the  beginning  of    the    period,    the   transactions  of 
the  period  shown  by  the  sundry  records  and  memoranda. 

5.  To  convert  a  single  entry  set  of  books  to  a  double 
entry  system  is  not  at  all  difficult.     The  same  ledger  may  be 
used  if  desired.     First,  prepare  a  statement  of  assets  and  lia- 
bilities.    Second,  determine  the  profit  or  loss  for  the  period. 
Third,  prepare  a  journal  entry,  debiting  all  assets,  crediting  all 
liabilities,  and  crediting  the  proprietor  for  the  net  investment. 
If  the  proprietor  is  not  credited  for  the  net  profit  or  debited 
for  the  net  loss  before  preparing  the  above  entry,  a  second 
journal  entry  will  be  necessary  to  adjust  the  proprietor's  account 
and  the  Profit  and  Loss  account.    If  the  same  ledger  is  to  be  re- 
tained, those  accounts  which  already  appear  in  the  ledger  should 
be  checked  so  as  not  to  be  posted  again.     If  a  new  ledger  is  to 
be  opened,  all  entries  must  to  be  posted. 


DOUBLE,  ENTRY  BOOKKEEPING 

With  this  system  a  complete  record  of  every  transaction  is 
kept  showing  its  effects  upon  both  nominal  and  real  accounts. 
There  is  a  constant  equilibrium  maintained  at  all  times  for 
every  debit  is  offset  by  an  equivalent  credit,  and  every  credit 
by  an  equivalent  debit. 

The  advantages  of  double  entry  bookkeeping  are  many. 
Among  them  are  to  be  mentioned. 

(a)  A  Trial  Balance  can  be  taken  from  the  ledger  at  any 
time,  thereby  determining  the  accuracy  of  the  posting  and  the 
equilibrium  of  the  accounts. 

(b)  A  Profit  and  Loss  statement  can   be  prepared   from 
the  nominal  accounts  and  a  Balance  Sheet  from  the  real  accounts 
without  analyzing  the  transactions. 

(c)  The  journal  and  the  ledger  can  be  balanced  indepen- 
dent of  each  other  thereby  acting  as  a  check  one  upon  the  other. 

(Note.  It  is  assumed  that  students  taking  up  this  course  in  Public 
Accounting  and  Auditing  are  familiar  with  the  principles  of  elementary  book- 
keeping, both  single  entry  and  double  entry,  and  with  the  ordinary  pro- 
cedure in  actual  business  routine.  If  anyone  proposes  to  take  up  this  course 
of  study  who  has  not  had  a  fairly  thorough  training  in  bookkeeping,  it  is 
suggested  that  he  secure  a  copy  of  "20TH  CENTURY  BOOKKEEPING 
AND  ACCOUNTING,"  by  James  W.  Baker,  published  by  the  South- 
western Publishing  Co.,  Cincinnati,  Ohio. 

This  text  is  commended  because  it  is  up-to-date  as  regards  modern  busi- 
ness methods  and  accounting  terminology.  Laboratory  work  is  also  provided 
for  use  in  connection  with  the  text,  making  it  a  comparatively  simple  matter 
to  secure  a  theoretical  and  practical  knowledge  of  bookkeeping  and  account- 
ing.) 


12  PUBLIC  ACCOUNTING  AND  AUDITING 

COMMERCIAL  LAW 
and  its  Contact  with  Accounting 

The  American  Institute  of  Accountants  and  every 
state  having  a  C.  P.  A.  law  has  among  its  requirements  an 
examination  on  commercial  law. 

The  field  of  business  venture  with  which  the  accountant  is 
concerned  is  so  broad  in  its  scope  that  instances  have  arisen  in 
which  a  knowledge  of  the  principles  of  all  branches  of  law  has 
been  necessary,  excepting  such  subjects  as  admiralty,  pleading, 
torts,  patent  law,  questions  on  constitutional  and  criminal  law, 
and  a  few  other  special  subjects. 

In  examinations  of  large  manufacturing  corporations,  ac- 
countants are  liable  to  encounter  questions  involving  the  general 
as  well  as  the  statute  laws  governing  corporations;  the  law  of 
contracts,  applying  to  notes,  sales,  agency,  insurance,  bailments, 
chattel  mortgages,  liens,  landlord  and  tenant,  mortgages,  etc,; 
real  property  law;  and  the  state  and  federal  statutes  relating 
to  the  duties  and  obligations  to  report  the  extent,  nature  and 
cost  of  the  various  branches  of  work. 

In  investigations  of  receiverships  a  knowledge  of  the  rules 
and  practices  in  the  courts  is  necessary. 

In  the  preparation  of  Income  and  Excess-Profits  Tax 
returns  a  knowledge  of  the  Income  Tax  laws  and  regulations 
is  a  necessity.  In  recent  years  this  has  become  a  prominent 
part  of  the  accountant's  work. 

Examinations  of  testamentary  trusts  and  estates  of  de- 
cedents require  a  knowledge  of  the  law  of  real  property,  the 
law  relating  to  wills,  administration,  partnership,  including  a 
knowledge  of  statutory  and  common  law  and  equity,  and  of 
the  law  of  practice  and  procedure  at  law  in  the  different  courts. 

It  will  be  seen,  therefore,  that  commercial  law  has  but  few 
limitations.  To  the  uninitiated,  it  would  seem  to  be  a  very 
difficult  matter  to  gain  a  sufficient  knowledge  of  commercial 
law.  However,  it  is  not  as  difficult  as  it  at  first  appears  to  be. 

An  accountant  would  not  be  expected  to  have  an  accurate 
knowledge  of  the  various  statutes  of  the  different  states,  but 
he  should  know  when  a  statute  would  be  likely  to  cover  the  case 
at  hand.  Invariably  there  will  be  sufficient  time  to  look  up 
a  statute,  therefore,  it  is  not  demanded  that  accountants  have 
more  than  a  general  acquaintance  with  the  statutes. 

Of  course,  such  statutes  as  the  STATUTE  OF  FRAUDS, 
the  NEGOTIABLE  INSTRUMENTS  LAW,  the  UNIFORM 
SALES  ACT,  and  BANKRUPTCY  LAWS  should  be  well  under- 
stood. The  statute  of  frauds  and  the  negotiable  instruments 
law  are  nearly  uniform,  having  been  adopted  in  most  of  the 
states  of  the  union. 


CONTACT  OF  COMMERCIAL  LAW  WITH  ACCOUNTING        13 


SUBDIVISIONS  OF  LAW 

Generally  speaking,  law  may  be  classified  as  either  WRIT- 
TEN or  UNWRITTEN. 

Written  law  is  the  law  set  forth  in  our  federal  and  state 
constitutions  and  our  federal  and  state  statutes. 

Unwritten  law  comes  from  the  reported  decisions  of  courts. 
Not  all  rights  and  duties  as  between  individuals  have  been 
defined  by  either  state  or  federal  constitutions  or  statutes. 
When  written  law  does  not  cover  a  case,  unwritten  law  applies. 

The  law  of  the  land  is  called  MUNICIPAL  LAW.  In  this 
country  it  is  partially  written  and  partially  unwritten.  The 
written  law  is  subdivided  into  CONSTITUTIONAL  and 
STATUTE  LAW.  Unwritten  law  is  often  referred  to  as  COM- 
MON LAW. 

The  order  of  importance  or  precedence  of  the  various  kinds 
of  law  is  as  follows: 

1.  Federal  constitutional  law. 

2.  Federal  statute  law. 

3.  State  constitutional  law. 

4.  State  statute  law. 

5.  Common  law. 

A  law  is  declared  UNCONSTITUTIONAL  when  the  courts 
decide  that  it  conflicts  with  the  laws  of  higher  order.  An  example 
of  this  is  the  recent  decision  of  the  Supreme  Court  of  the  United 
States,  declaring  unconstitutional  that  part  of  the  1916  Income 
Tax  Law  which  placed  a  tax  on  stock  dividends. 

Commercial  law  is  that  part  of  municipal  law  which  applies 
to  commerce,  that  is,  to  business  transactions. 

The  following  chart  shows  clearly  the  main  divisions  of 
Municipal  law: 

[Federal 
i.     Constitutional  < 

State 


Municipal  Law. 


2.     Statute 


Federal 


fCivil 


State 


[Criminal 
[Civil 
[Criminal 

[Suits  at  Law 
[Civil 
3.     Common  j  [Suits  in  Equity 

[Criminal 


14  PUBLIC  ACCOUNTING  AND  AUDITING 

A.    THEORY  QUESTIONS 

1.  What  are  the  major  objects  of  an  audit?    C.  P.  A.  Mich. 

2.  Give  a  brief  outline  of  the  duties  and  responsibilities 
of  an  auditor  and  what  special  qualifications  and  training  he 
should  possess.  C.  P.  A.  La. 

3.  Explain  how  certified  statements  extending  over  a  period 
of  years  might  facilitate  the  sale  of  a  business. 

4.  (a)  What  is  your  understanding  of  the  term  accounting? 
(b)  What  constitutes  a  scientific  system  of  accounts? 

C.  P.  A.  Ind. 

5.  Define  bookkeeping.    State  various  kinds  with  explana- 
tions. C.  P.  A.  Mich. 

6.  State   the   relative   advantages  and  disadvantages  of 
single  entry  and  double  entry  bookkeeping.  C.  P.  A.  Ohio 

7.  State  the  essential  principles  of  double  entry  bookkeep- 
ing, and  show  wherein  it  differs  from  single  entry  bookkeeping. 

C.  P.  A.  N.  Y. 

8.  The  A.   I.  Mfg.  Co.  employs  a  staff  of  bookkeepers. 
The  head  bookkeeper  has  not  studied  the  theory  of  accounting, 
neither   has   his   experience   been   extensive.      He   understands 
double  entry  bookkeeping,  but  he  cannot  be  described  as  a  well 
trained  accountant. 

Previously  the  A.  I.  Mfg.  Co.  has  been  satisfied  with  annual 
accounts  prepared  by  competent  auditors.  They  decide  to  have 
monthly  statements  of  accounts  in  the  future,  and  with  this  end 
in  view,  instruct  the  head  bookkeeper  to  prepare  statements 
on  the  same  lines  as  the  last  annual  accounts  were  prepared. 

State  several  imaginary  errors  of  principle  that  might  not 
unreasonably  be  found  upon  an  expert  examination  of  his  work. 

C.  P.  A.  111. 

9.  How  would  you  determine  the  profits  for  a  given  period 
from  a  set  of  books  kept  by  the  single  entry  system,  the  capital 
at  the  beginning  of  the  period  being  known?  C.  P.  A.  Me. 

10.  What  information  can  you  get  from  a  set  of  books 
kept  by  double  entry  which  you  can  not  get  from  a  set  kept  by 
single  entry?  C.  P.  A.  Mich. 


ACCOUNTING  PROBLEMS  15 

B.    ACCOUNTING  PROBLEMS 

1.  The  following  information  is  obtained  from  a  set  of 
books  kept  by  the  single  entry  method: 

Capital  at  Beginning  of  Period $8,500.00 

Withdrawal  from  Investment  during  Period.     1,000.00 

Additional  Investment  during  Period 2,500.00 

Present  Capital 12,500.00 

Find  the  net  profit  or  loss. 

2.  Day  and  Wright  have  been  doing  business  as  partners, 
and  have  kept  their  books  by  single  entry.     From  their  books 
and  Inventory  you   find   the  following  Assets  and  Liabilities: 
Mdse.   $9,241.00;    Cash,  $850.00;    Real    Estate,  $3,000;    Bills 
Payable,  $975-oo;  W.  M.  Day's  Capital,  $5,390;  T.  J.  Wright's 
Capital,  $6,400.00.      They  owe  personal   accounts,   $4,175.00. 
Persons  owe  them,  $6,941.00.     Store  fixtures,  $571.00.     Profits 
are  shared  equally. 

Determine  the  loss  or  gain.  Draft  a  journal  entry  to  change 
the  books  from  single  entry  to  double  entry,  assuming  that  the 
old  ledger  is  to  be  retained  and  used  with  the  new  system. 

3.  Prepare  steps  and  show  procedure  necessary  to  convert 
to  double  entry  from  single  entry  the  schedule  of  assets  and 
liabilities  of  which,  taken  from  the  latter,  appear  as  follows: 

Assets 

Cash .$12,000.00 

Merchandise  Inventory 7,500.00 

Notes  Receivable 1,500.00 

Accounts  Receivable 5,000.00 

Real  Estate 3,500.00 

Plant  and  Equipment 2,000.00 

Furniture  and  Fixtures 1,000.00 


$32,500.00 

Liabilities 

Notes  Payable $  4,000.00 

Accounts  Payable 8,500.00 

Excess  of  assets  over  liabilities,  being  capital    20,000.00 


$32,500.00 

(Assume  that  a  new  ledger  is  to  be  opened.  Draft  a 
journal  entry  to  change  the  books  from  single  to  double  entry 
but  do  not  set  up  ledger  accounts.)  C.  P.  A.  Ind. 


16  PUBLIC  ACCOUNTING  AND  AUDITING 

C.    LEGAL  QUESTIONS 

1.  What  is  meant  by  "municipal"  law? 

2.  Name  three  kinds  of  "municipal"  law. 

3.  Show  wherein  constitutional  law  differs  from  statute 
law. 

4.  Common  law  is  sometimes  also  called  the  "unwritten" 
law.     Explain  why. 

5.  Give  the  order  of  precedence. 

6.  When  there  is  a  conflict  between  a  statute  and  common 
law,  which  takes  precedence? 

7.  Why  is  a  general  knowledge  of  legal  principles  desirable? 

C.  P.  A.  Ind. 

8.  (a)  Define  commercial  law. 

(b)  What  are  the  general  divisions  of  law? 

C.  P.  A.  Mich. 


Chapter  Two 

BEGINNING  AN  AUDIT 

Engagement  Blank.  Accountants  as  a  rule  have  a  form 
known  as  an  engagement  blank.  This  is  carefully  filled  in  at 
the  time  the  agreement  is  made  or  as  soon  thereafter  as  is  con- 
venient. The  form  of  engagement  blank  used  by  the  author 
is  illustrated  on  page  18.  The  form  may  vary,  but  should  show 
all  the  facts  in  connection  with  the  agreement  made  with  the 
client.  It  is  important  that  an  auditor  should  have  with  him 
a  copy  of  the  engagement  blank  for  convenient  reference. 

Letter  of  Introduction.  In  starting  out  on  an  engage- 
ment one  is  sure  to  come  in  contact  with  a  number  of  different 
persons.  Naturally  he  will  go  first  to  the  client.  He  will  also 
need  to  meet  heads  of  departments  and  others  in  arranging  to 
begin  the  work.  It  is,  therefore,  important  that  he  have  a  letter 
of  introduction.  Remember  an  auditor  is  engaged  in  professional 
work  and  the  nature  of  his  work  and  the  liberties  extended  him 
are  such  that  he  should  be  properly  introduced. 

Equipment.  In  the  way  of  equipment,  an  auditor  will 
need  journal,  ledger,  and  analysis  paper.  Analysis  paper  may 
be  secured  with  almost  any  number  of  columns.  Fourteen 
columns  is  well  adapted  to  the  use  of  the  Working  Sheet  and  is 
therefore  preferable.  He  will  also  need  black,  blue  and  red 
pencils,  an  eraser,  a  ruler,  bank  certificates  in  blank,  time  and 
expense  report  blanks,  and  a  memorandum  book. 

NATURE  OF  ENGAGEMENT 

The  first  thing  of  importance  at  this  point  is  to  know 
in  your  own  mind  exactly  what  you  are  going  to  do.  Heretofore 
the  business  public  has  depended  upon  the  auditor  and  ac- 
countant as  to  the  scope  of  the  work  and  in  many  cases  the  work 
has  been  started  without  knowing  in  advance  exactly  the  nature 
and  scope  of  the  engagement.  There  should  be  a  clear  under- 
standing reached  with  the  client  by  the  accounting  firm,  and 
this  in  turn  should  be  conveyed  to  the  senior  in  charge  of  the 
audit.  The  junior  should  understand  definitely  just  what  part 
of  the  audit  he  is  to  be  responsible  for  and  should  proceed  ac- 
cordingly. Of  course,  it  is  needless  to  say  that  he  will  get  his 
information  direct  from  the  senior  and  not  from  the  client. 
(Continued  on  page  19) 

17 


18  PUBLIC  ACCOUNTING  AND  AUDITING 


ENGAGEMENT  BLANK 


Cincinnati,  Ohio 

Certified  Public  Accountant 
and  Auditor 

Cincinnati,  Ohio, 

1.  Client  The   Blank  Manufacturing  Company.. 

2.  Official  position.  .  .Board  of  Directors  .......... 

3.  Address  ____  Indianapolis,    Indiana  ........... 

4.  Conference  ____  C.    H.    Becker,    Chairman./.  — 

5.  File  No  .....  A345  ................................... 

6.  Telephone  No  .....  Main   £4  ........................ 

7.  Report  to  be  addressed  to.  Mr  .    Becker  .............. 

8.  Account  to  be  opened  with.  The    Blank   Mf  g  .    Co  ... 

9.  Nature  of  engagement.  .Balance    Sheet  Audit.  .  .  . 
for   credit  purposes  ......................... 

10.  Work  to  be  done  at.,  their    office  ................ 

11.  Nature  of  the  business.  manufacturing  ............. 

12.  When  to  be  commenced.  Jan.     15,     1919  ........... 

13.  Probable  time  required  .  .  two    weeks  ................. 

14.  Accountants  required  one    senior;    two    juniors 

15.  Rates...  regular  .............  .  .................... 

16.  Additional  information.  .No    previous    audit    has 
ever   been  made   but    an   internal   check 
is   maintained.       Mr.    Becker   called  at 
our    office   Dec.    20,    1918  ................. 

Engagement  No  .......  One  .  .  .         Date  completed  ........... 

Assigned  to  staff  ......  A  ......         Report  mailed  ............ 


THE  VALUE  OF  AN  AUDIT  19 

In  determining  the  nature  of  the  engagement  and  making 
arrangements  for  the  audit  with  the  client,  naturally  it  is  fre- 
quently necessary  to  explain  the  different  classes  of  audits. 
The  client  is  likely  to  state  that  he  wants  a  complete  audit 
when,  as  a  matter  of  fact,  he  wants  only  a  Balance  Sheet  audit. 
It  is  of  the  utmost  importance  that  there  be  no  misunderstanding 
between  the  auditor  and  his  client  as  to  the  exact  scope  of  the 
audit. 

THE  VALUE  OF  AN  AUDIT 

The  value  of  an  audit  will  naturally  depend  upon  each 
individual  instance.  Business  men  have  been  somewhat  slow 
to  realize  the  actual  benefits  to  be  derived  from  periodical 
audits  by  professional  accountants,  but  today  the  importance 
of  an  audit  is  generally  recognized  by  the  business  community. 
It  is  not  infrequent,  however,  that  we  still  hear  business  men 
say  that  in  their  particular  case  an  audit  is  unnecessary.  They 
say  that  they  have  absolute  confidence  in  their  bookkeeper 
or  accountant  and  that  he  is  able  to  prepare  annual  statements 
that  are  just  as  accurate  as  anyone  could  prepare.  Others  say 
that  they  know  exactly  where  they  stand  in  the  financial  sense 
and  do  not  need  an  outsider  to  point  out  defects,  or  to  plan 
improvements  hi  the  accounting  system  in  use. 

Questions  such  as  the  following  should  cause  business  men, 
stockholders,  directors,  investors  and  others  to  realize  that  such 
arguments  as  the  above  are  groundless:  Are  you  certain  that 
your  bookkeeper  is  competent  to  furnish  an  accurate  statement 
of  financial  condition  or  of  earnings?  Has  your  general  manager 
had  sufficient  accounting  training  and  experience  to  judge  of 
the  correctness  of  the  reports  which  he  submits  periodically?  Do 
you  know  that  corporations  frequently  pay  dividends  which 
have  not  been  earned,  though  it  is  illegal  to  do  so?  Is  your 
general  manager  competent  to  prepare  for  the  United  States 
Government,  returns  for  Income  and  Excess-Profits  Taxes? 
Even  though  your  attorney  is  consulted  with  regard  to  these 
returns,  are  you  sure  that  he  fully  comprehends  the  application 
of  the  Income  Tax  Law  and  all  the  regulations  of  the  Treasury 
Department?  Is  he  able  to  interpret  your  accounts  and  deter- 
mine the  accuracy  of  your  returns?  It  is  such  questions  as 
these  that  only  a  professional  accountant  with  wide  training 
and  experience  is  competent  to  pass  upon. 

A  bookkeeper  may  perform  his  detail  work  so  accurately 
that  for  years  his  books  are  always  in  balance  and  errors  in 
posting  or  in  footing  the  accounts  are  unknown,  yet  the  state- 
ments which  he  presents  are  not  only  in  such  form  as  to  convey 
little  information  of  value,  but  the  figures  which  he  shows  as 
earnings  may  never  be  correct.  An  audit  of  his  books  may 
disclose  the  fact  that  accounts  receivable,  amounting  to  thou- 


20  PUBLIC  ACCOUNTING  AND  AUDITING 

sands  of  dollars,  have  been  carried  at  full  value  though  known 
to  be  uncollectible.  He  may  not  have  made  provision  for  de- 
preciation of  plant  and  machinery.  Equipment  which  has 
become  worthless  because  of  depreciation  or  obsolescence  may 
be  shown  in  the  statements  at  its  original  cost. 

These  are  some  of  the  things  which  an  average  bookkeeper, 
even  one  whose  services  command  a  big  salary,  knows  but 
little  or  nothing  about.  If  he  does  know  something  of  the  neces- 
sity for  adjustments  of  this  kind,  his  lack  of  experience  and 
theoretical  knowledge  is  a  dangerous  thing,  and  his  attempt  to 
put  this  theory  into  practice  is  likely  to  mar  the  result. 

Don't  think  for  a  moment  that  the  present  day  work 
of  an  auditor  is  merely  a  checking  of  the  footings  and 
postings.  This  part  of  his  work  requires  the  least  amount  of 
ability  and  experience.  It  is  an  auditor's  duty  to  go  much 
further — to  determine  the  accuracy  of  the  figures  stated  on  the 
books  of  account;  to  distinguish  between  capital  and  revenue 
expenditures;  to  determine  the  actual  value  of  accounts  with 
customers  through  a  process  of  testing,  or,  if  necessary,  to  cor- 
respond with  each  customer  to  secure  a  verification  of  the 
account;  to  determine  a  conservative  and  sound  basis  for  the 
estimation  of  depreciation  on  all  assets;  and  to  secure  authority 
for  making  all  necessary  adjustments.  These  things  can  be 
brought  about  through  courteous  cooperation  between  the 
officers  and  employees  of  the  company  and  the  accountants. 

The  professional  accountant's  work  would  not  be  satisfac- 
tory if  he  were  to  submit  statements  of  financial  condition 
which  are  simply  in  accord  with  the  books  of  account.  He 
must  determine  that  none  of  the  assets  are  overvalued  and  that 
all  liabilities  are  stated.  The  latter  may  mean  the  determining 
of  liabilities  on  account  of  accommodation  endorsements  of 
notes  and  other  negotiable  instruments,  guaranties,  warranties, 
etc.  The  head  bookkeeper  of  a  concern,  in  preparing  statements 
of  financial  condition,  is  certain  to  be  influenced  by  the  wishes 
of  the  management,  but  an  accountant  must  of  necessity  pre- 
pare his  statements  so  as  to  show  the  absolute  facts;  he  must 
be  impartial.  To  fail  in  this  is  to  become  morally  and  legally 
liable  for  having  failed  to  use  the  skill  of  a  professional  account- 
ant. 

Periodical  audits  by  professional  accountants  are  necessary 
in  hard  times  when  competition  is  keen  and  profits  small, 
because  in  such  times  operating  cost  must  be  carefully  analyzed 
and  reduced  to  a  minimum.  The  auditor  must  determine  where 
the  expenditures  have  been  made,  why  they  were  made  and 
what  the  results  were.  He  must  find  out  if  there  are  any  leaks 
and  suggest  a  .way  to  stop  them. 

An  auditor's  report  may  disclose  that  during  a  period  when 
sales  were  abnormally  large,  the  results  show  a  loss  as  compared 


THE  VALUE  OF  AN  AUDIT  21 

with  previous  periods  when  sales  were  considerably  less.  His 
report  may  show  that  one  department  is  suffering  a  loss,  yet 
the  entire  business  shows  a  gain.  His  report  may  show  that 
operating  expenses  in  one  department  are  abnormally  high  and 
he  may  be  able  to  show  how  they  could  be  lowered. 

In  many  instances,  it  has  been  found  profitable  to  secure 
an  accountant  to  install  a  system  of  accounting  and  to  make 
arrangements  for  the  accounting  to  be  done  under  his  super- 
vision. When  this  is  done,  the  work  of  the  bookkeeper  is  per- 
formed and  statements  are  prepared  under  the  oversight  of  a 
highly  trained  and  widely  experienced  professional  accountant, 
and  usually  at  a  very  reasonable  cost  as  compared  with  the 
value  of  the  accountant's  services  if  confined  to  the  individual 
firm ;  yet  with  such  arrangements  the  accountant  may  be  consult- 
ed any  time,  even  over  the  telephone.  Unusual  and  difficult 
problems  may  be  placed  before  him  before  the  bookkeeper  has 
recorded  them,  thus  avoiding  errors  and  misstatements. 

There  is  not  the  slightest  doubt  as  to  the  value  of  an  audit 
when  performed  by  a  skilled  professional  accountant  or  auditor, 
and  it  is  exceedingly  doubtful  if  any  corporation  or  business 
firm  can  afford  to  do  without  an  audit. 

The  professional  accountant  is  an  efficiency  engineer  in 
times  of  prosperity.  He  sets  the  signals  which,  unless  they 
are  disregarded,  keep  the  business  train  running  without  acci- 
dent. He  is  the  wreckmaster  who  gathers  up  the  pieces,  sets 
them  on  the  track  and  starts  them  going — if  possible — after 
a  concern  has  been  ditched. 

When  a  rich  man  dies,  the  public  accountant  examines 
and  appraises  his  estate.  His  range  of  activities  covers  the 
whole  field  of  business  existence,  from  birth  to  death,  and  the 
interval  between. 

KINDS  OF  AUDITS 

Audits  may  be  either  complete  or  partial.  A  complete  audit 
is  known  as  a  DETAILED  audit;  a  partial  audit  is  usually 
known  as  a  BALANCE  SHEET  audit.  Since  the  average 
business  man  has  no  idea  of  the  difference  in  the  two  main 
classes  of  audits,  a  careful  explanation  must  be  made  so  that 
he  will  know  in  advance  just  what  kind  of  an  audit  he  is  getting. 
He  will  frequently  ask  the  auditor  to  make  a  recommendation 
in  the  matter.  It  is  quite  impossible  and  inadvisable  to  do 
so  without  a  preliminary  inspection  of  the  books  and  conditions 
existing.  The  detailed  audit  is  the  ideal  audit  but  the  time  and 
expense  of  such  an  audit  is  not  always  advisable  nor  is  it  always 
necessary.  In  determining  this  matter  much  will  depend  upon 
whether  a  satisfactory  internal  check  has  been  maintained. 


22  PUBLIC  ACCOUNTING  AND  AUDITING 

Internal  Audit.  By  an  internal  audit  or  check  is  meant  a 
continuous  audit  by  someone  within  an  organization,  or  by  the 
system  being  so  planned  that  no  one  employee  has  complete 
control  of  any  part  of  the  accounts.  A  properly  planned  internal 
check  is  important  and  when  carried  out  satisfactorily,  a  Balance 
Sheet  audit  will  be  found  sufficient,  unless  fraud  or  dishonesty 
is  suspected. 

While  large  firms  usually  employ  someone  who  acts 
as  auditor  and  who  maintains  a  continuous  audit,  yet  a  large 
majority  of  firms  do  not  employ  such  a  person,  but  simply 
plan  the  office  work  in  such  a  way  as  to  secure  the  best  internal 
check.  The  exact  division  of  the  work  in  an  office  so  as  to  secure 
a  satisfactory  internal  check  would  depend  very  largely  upon 
the  surrounding  circumstances. 

In  planning  a  system  of  accounts  for  a ,  jobbing  house, 
wherein  five  persons  kept  the  books,  did  the  billing,  made  the 
city  collections,  handled  the  general  and  petty  cash,  and  paid 
all  the  invoices,  the  following  method  was  advocated  and  later 
found  to  be  very  satisfactory: 

It  was  arranged  for  one  person  to  keep  the  general  ledger 
and  record  the  invoices;  a  second  to  handle  the  cash;  a  third 
to  keep  the  sales  ledger;  a  fourth  to  do  the  billing;  and  a  fifth 
to  make  collections,  etc.  The  work  may  be  still  further  sub- 
divided, depending  upon  the  volume  of  business.  For  instance, 
one  man  might  handle  only  cash  receipts  and  another  man 
handle  cash  payments,  or  one  man  might  handle  cash  receipts 
from  customers  keeping  a  special  customers'  cash  book.  All 
this  subdivision  of  the  work  will  depend  upon  the  volume  of 
business.  The  important  feature  is  that  the  cash  book  and 
ledger  be  kept  by  different  persons  so  that  one  person  acts  as 
a  check  upon  the  other.  Some  accountants  recommend  that 
persons  in  the  office  exchange  duties  at  times,  the  theory  being 
that  in  so  doing  one  person  might  detect  dishonesty  on  the  part 
of  another.  From  the  standpoint  of  efficiency,  this  procedure 
might  be  argued  as  unwise. 

Without  a  doubt,  vacations  should  be  insisted  upon.  The 
author  recalls  an  experience  of  a  teller  in  a  bank  who  for  a  period 
of  three  years  constantly  embezzled  the  bank,  and  although  the 
books  had  been  audited  periodically  by  bank  examiners,  he  had 
been  able  to  cover  up  the  shortage  so  that  it  had  not  been  detect- 
ed, but  finally,  while  away  on  a  vacation,  the  bank  examiner 
made  an  unexpected  call  and  during  the  process  of  his  investiga- 
tion uncovered  a  shortage  of  $10,000  in  the  teller's  accounts. 
This  illustration  is  mentioned  as  one  reason  why  vacations 
should  be  insisted  upon  from  the  standpoint  of  an  internal  check. 

Cash  Audit.  The  so-called  cash  audit  is  practically  a 
balance  sheet  audit  or  partial  audit,  but  it  is  difficult  to  under- 
stand how  an  audit  of  cash  could  be  made  without  leading 


KINDS  OF  AUDITS  23 

to'the  consideration  of  many  other  accounts  and  records.  Fraud 
and  errors  of  principle  are  not  necessarily  confined  to  cash  in 
any  sense,  and  are  far  more  likely  to  be  uncovered  somewhere 
else. 

Balance  Sheet  Audit.  A  Balance  Sheet  audit  is  made 
with  the  view  of  preparing  a  correct  Balance  Sheet  as  at  a  certain 
date.  It  not  only  includes  the  verification  of  stated  assets  and 
liabilities  but  also  the  discovery  of  any  unstated  assets  and  liabili- 
ties.] Furthermore ,  the  auditor  must  ascertain  if  all  the  liabilities 
have  been  incurred  with  proper  authority.  In  the  case  of  a 
corporation  it  will  be  found  frequently  that  certain  liabilities  were 
incurred  without  authority  from  the  board  of  directors. 

Detailed  Audit.  As  stated  above,  the  detailed  audit  is 
the  ideal  audit.  It  comprehends  a  complete  audit  of  all  income 
and  expenditures  during  the  period,  including  the  checking  of 
all  records,  vouchers,  footings,  postings,  etc.  The  detailed 
audit  is  seldom  carried  out  in  full.  A  process  called  TESTING 
is  resorted  to  quite  often  in  both  a  Balance  Sheet  and  a  detailed 
audit.  It  consists  in  picking  out  the  transactions  for  a  certain 
period  and  if,  after  carefully  vouching  these  transactions  they 
are  found  to  be  correct,  it  is  then  assumed  that  the  transactions 
for  the  whole  period  under  audit  are  reasonably  correct. 

Contingent  Fees.  The  question  as  to  the  advisability  of 
an  auditor  accepting  a  contingent  fee  frequently  comes  up. 
While  under  certain  circumstances  it  may  be  safe  to  accept  a 
fee  based  upon  the  results  of  the  audit,  it  is  doubtful  if  the 
plan  is  to  be  encouraged.  At  any  rate  it  is  not  considered  good 
ethics  by  the  American  Institute  of  Accountants  which  has  gone 
on  record  as  opposed  to  the  practice.  To  illustrate  what  is  meant 
by  a  contingent  fee,  a  client  approaches  an  auditor  stating 
that  he  desires  an  audit  made  with  the  view  to  obtaining  a  loan 
from  his  banker  and  states  that  the  fee  will  be  based  upon  the 
auditor's  success  in  aiding  him  to  secure  the  loan  through  the 
preparation  of  a  Balance  Sheet  for  credit  purposes.  The  auditor 
who  undertakes  such  an  engagement  would  not  be  likely  to  pre- 
pare an  impartial  report. 

Audit  Program.  At  the  beginning  of  the  engagement  the 
auditor  should  prepare  a  program.  Naturally  it  will  differ, 
depending  upon  the  scope  of  the  engagement,  the  nature  of  the 
business,  and  the  purpose  of  the  audit,  but  it  usually  will  be  along 
lines  similar  to  the  following: 

1.  Count  the  cash;   verify  bank  balances;    read   minutes. 

2.  List  notes  and  securities  on  hand. 


24  PUBLIC  ACCOUNTING  AND  AUDITING 

3.  If  a  Trial  Balance  is  furnished,  check  it  with  the  general 
ledger. 

4.  Check  list  of  accounts  receivable  and  accounts  payable 
with  controlling  accounts. 

5.  Check  any  other  subsidiary  lists  of  accounts  with  con- 
trolling accounts. 

6.  Check  extensions  and  footings  of  inventories;    test  the 
inventory. 

7.  Verify  outstanding  capital  stock  by  comparison  of  stock 
ledger  accounts  with  stubs  of  stock  certificate  book. 

8.  Check  all  footings  of  books  of  account,  both  original  and 
final ;   check  all  postings  or  transfers  from  one  book  to  another. 

9.  Review  cash   disbursements;  compare  with  cancelled 
checks. 

10.     Ascertain   if  proper    provision    has    been    made    for 
depreciation. 


Legal  Responsibility  of  Client.  It  is  not  out  of  place 
here  to  mention  the  fact  that  it  is  always  advisable  to  determine 
the  legal  responsibility  of  a  client  before  accepting  an  engagement. 
If  someone  within  an  organization  seeks  to  have  an  audit  made, 
it  is  necessary  to  ascertain  whether  or  not  he  has  any  right 
to  engage  the  services  of  an  auditor,  and  also  as  to  whether 
or  not  he  is  employing  you  personally,  or  is  merely  acting  as  an 
agent  of  the  company. 


CLASSIFICATION  OF  ACCOUNTS  25 


CLASSIFICATION  OF  ACCOUNTS 

It  is  important  that  an  accountant  or  auditor  should  thor- 
oughly understand  a  proper  classification  of  accounts.  In  the  next 
chapter  there  is  to  be  taken  up  what  is  known  as  a  Balance  Sheet 
audit;  therefore,  it  is  necessary  at  this  point  to  devote  a  brief  dis- 
cussion to  the  subdivisions  of  accounts.  Since  a  Balance  Sheet  is 
made  up  of  ASSETS  and  LIABILITIES,  these  will  now  be 
discussed  and  classified. 

REAL  ACCOUNTS 

Accounts  are  divided  into  two  general  classes — REAL  and 
NOMINAL.  It  is  the  real  accounts  that  appear  in  the  Balance 
Sheet  ana  arc  ciassea  as  assets  and  liabilities;  they  may  be  either 
PERSONAL  or  IMPERSONAL.  There  are  three  classes  of 
personal  accounts :  accounts  with  customers ;  accounts  with  cred- 
itors; and  accounts  with  owners  or  proprietors.  Accounts  with 
customers  are  usually  classed  as  CURRENT  assets.  There 
might  be  an  exception  to  this  in  the  case  of  an  open  account, 
the  terms  of  which  would  indicate  that  it  would  not  become 
due  within  a  year.  Some  authorities  hold  that  all  current 
assets  must  be  those  which  can  be  realized  upon  within  the  cur- 
rent fiscal  period,  or,  at  least,  within  a  year.  However,  it  is 
conceded  good  practice  to  class  all  accounts  with  customers 
as  current  assets  as  long  as  these  accounts  are  collectible.  Once 
an  account  is  considered  uncollectible,  or  its  collection  as  being 
doubtful,  it  should  immediately  be  charged  off  and  should  not 
be  included  as  a  current  asset  without  the  proper  depreciation 
being  set  up. 

Accounts  with  creditors  are  considered  as  CURRENT  lia- 
bilities; like  accounts  with  customers,  they  are  usually  due 
within  a  short  time  and,  therefore,  provision  must  be  made 
for  their  liquidation  within  the  current  fiscal  period. 

The  accounts  with  the  owners  or  proprietors  of  a  business 
are  classified  on  the  liability  side  of  the  Balance  Sheet,  but  are 
usually  listed  separate  from  the  liabilities  in  a  section  devoted 
to  proprietorship  accounts.  They  may  be  in  the  form  of  an 
account  with  a  single  owner,  accounts  with  partners,  or  accounts 
with  capital  stock,  and  SURPLUS  or  DEFICIENCY.  In 
the  case  of  a  corporation,  net  profits  are  usually  credited  to  a 
Surplus  account  or  they  might  be  credited  to  an  Undivided 
Profits  account,  in  which  case  this  account  would  also  appear 
among  the  proprietorship  accounts.  Net  losses  are  debited  to 
the  Surplus  account,  but  when  a  business  becomes  insolvent, 
it  is  then  necessary  to  set  up  a  Deficiency  account  debiting  it 
with  the  net  excess  loss.  A  Deficiency  account  shows  that  the 
business  has  been  conducted  at  a  loss  and  that  the  value  of  the 
stock  owned  by  stock-holders  has  decreased  in  value  equal  to 
the  amount  of  the  deficiency. 

(Continued  on  page  27) 


26 


PUBLIC  ACCOUNTING  AND  AUDITING 


CLASSIFICATION  OF  ACCOUNTS 


Reali 


Personal 


[Accounts 
Assets — Current]  with 

(Customers 


Liabilities 


Impersonal 


Accounts 


Assets 


[Accounts 
Current  I  with 

(Creditors 

[Accounts 
Proprietorship  j  with 

(Proprietors 

!Cash 
Merchandise 
Notes  Receivable 

[Machinery 
Fixed]  Buildings 
(Equipment 


Liabilities 


Current 


Notes  Payable 

Dividends 
Payable 

Accrued  Ex- 
penses 


Nominal  < 


[Mortgages 
Fixed  <  Bonds 

Collateral  Loans 


[Merchandise  Sales 

Income]  Dividends  on  Investment  Stock 
(interest  on  Notes  Receivable 

[Advertising 
Operating  Cost]  Salaries 
(Rent 

(Profit  on  Real  Estate 
Sales  of  Waste  Paper 
Dbt.  Accts.  Collected 

[Burglary  Loss 
Special  Losses] 

(Loss  by  Flood 


CLASSIFICATION  OF  ACCOUNTS  27 

It  will  be  seen,  therefore,  that  personal  accounts  affect 
both  sides  of  the  Balance  Sheet,  accounts  receivable  appearing 
on  the  debit  side  as  assets,  and  accounts  payable  and  proprietor- 
ship accounts  appearing  on  the  credit  side  of  the  Balance  Sheet 
as  liabilities. 

Impersonal  accounts  represent  either  assets  or  liabilities. 
If  assets,  they  may  be  either  current  or  FIXED.  Impersonal 
current  assets  would  include  such  real  accounts  as  Cash,  Mer- 
chandise, Notes  Receivable  and  any  other  accounts  that  can 
be  converted  into  cash  quickly  and  that  do  not  constitute  a 
fixed  investment.  On  the  other  hand,  impersonal  fixed  assets 
are  those  accounts  which  represent  fixed  investments,  such  as 
machinery,  buildings,  equipment,  land  and  all  property  possessed 
and  used  directly  by  the  owner  himself  for  his  enjoyment,  or 
for  business  purposes,  and  maintained  in  fixed  condition  for  long 
periods  of  time  subject  only  to  wear  and  tear  and  depreciation 
on  account  of  use.  Impersonal  liabilities  are  likewise  classified 
as  either  current  or  fixed.  Those  obligations  which  must  be 
liquidated  within  a  short  time  are  current  liabilities  and  those 
obligations,  the  liquidation  of  which  is  deferred  to  a  future 
date  usually  beyond  the  present  fiscal  period,  are  fixed  liabilities. 
Notes  payable,  dividends  payable,  all  accrued  expenses,  deposits, 
guarantees,  and  similar  accounts,  are  classified  in  the  Balance 
Sheet  as  current  liabilities,  while  mortages,  bonds  and  collateral 
loans  which  do  not  mature  within  a  year  or  within  the  present 
fiscal  period,  are  listed  as  fixed  liabilities. 

The  Public  Service  Commission  of  New  York  says : 
"Funded  debt  comprises  all  debt  which  by  the  terms 
of  its  creation  does  not  mature  until  more  than  one 
year  after  date  of  creation". 

There  is  another  subdivision  of  assets  that  might  be  men- 
tioned here,  that  is,  assets  may  be  either  TANGIBLE  or  IN- 
TANGIBLE. Kester*  in  his  "Accounting,  Theory  and  Practice," 
says:  "Asset  and  liability  accounts  may  be  called  'real'  or 
'specific',  because  they  represent,  in  the  main,  properties  owned 
or  owed  which  are  definite  and  usually  tangible."  Intangible 
accounts  include  such  accounts  as  good  will,  trade  marks, 
patents,  copyrights,  titles,  trade  names,  franchises,  etc. 


NOMINAL  ACCOUNTS 

Nominal  accounts  are  subdivided  into  four  classes:  first, 
income  accounts;  second,  operating  cost  accounts;  third, 
special  profit  accounts;  fourth,  special  loss  accounts.  Nominal 
accounts  are  sometimes  referred  to  as  ECONOMIC  accounts. 


"Roy  B.  Kester,  Columbia  University 


28  PUBLIC  ACCOUNTING  AND  AUDITING 

Wildman,*  in  his  "Principles  of  Accounting",  says: 

"Real  accounts  are  those  which  reflect  financial 
conditions. 

"Nominal  accounts  are  those  which  reflect  changes 
in  financial  conditions." 

Under  the  heading  of  Income  should  be  included  ac- 
counts representing  mercantile  income,  income  from  commis- 
sions, income  from  professional  fees,  banking  income,  etc.  The 
exact  classification  will  depend  upon  the  nature  of  the  business. 
If  a  business  is  a  mercantile  business,  its  principal  income  will 
be  represented  by  returns  from  sales,  and  practically  all  other 
income  will  be  in  the  nature  of  special  profits.  If  the  business 
is  a  professional  business,  the  principal  income  will  be  from 
fees,  and  all  other  income  will  be  in  the  nature  of  special  profits. 
A  stock  broker's  income  would  be  in  the  nature  of  commissions; 
therefore,  it  is  to  be  noted  that  in  preparing  a  Profit  and  Loss 
statement,  the  arrangement  of  the  accounts  will  depend  upon 
the  nature  of  the  business.  A  man  whose  business  is  mercan- 
tile, but  who  chances  to  make  a  sale  of  a  piece  of  real  estate 
at  a  profit,  would  thereby  create  a  special  profit  not  in  his  usual 
line  of  business.  Likewise,  a  loss  by  burglary  is  to  be  considered 
a  special  loss  and  not  a  customary  loss  in  the  usual  course  of 
the  business.  Operating  costs,  sometimes  classed  as  operating 
expenses,  are  the  expenses  incident  to  the  operation  of  a  business 
such  as  advertising,  salaries,  rent,  heat,  light  and  all  similar 
expense  accounts.  Special  profits  and  special  losses  are  some- 
times listed  as  EXTRAORDINARY  or  EXTRANEOUS  pro- 
fits and  losses. 

A  Profit  and  Loss  statement  is  composed  of  nominal 
accounts.  The  usual  procedure  is  to  list  the  regular  income 
accounts  first,  followed  by  the  operating  expense  or  operat- 
ing cost  accounts,  thereby  determining  the  net  profit  or 
net  loss  from  operation.  This  would  be  followed  by  adding  the 
special  profits  and  deducting  the  special  losses,  to  ascertain  the 
net  profit  or  net  loss  for  the  period.  Naturally  the  owners,  includ- 
ing the  partners  and  stockholders,  are  interested  in  and  want  to 
know,  first,  what  their  total  net  income  has  been;  second,  what 
their  total  operating  cost  has  been  in  producing  the  net  income ; 
third  what  additional  profits  there  have  been;  and  fourth, 
what  additional  losses  have  been  incurred. 


*  Professor  of  Accounting  at  New  York  University. 


THE  LAW  OF  CONTRACTS  29 


THE  LAW  OF  CONTRACTS 

Note:  Since  the  LAW  OF  CONTRACTS  is  without  a  doubt  one  of 
the  most  important  parts  of  commercial  law,  naturally,  the  accountant  is 
primarily  concerned  with  it  and,  therefore,  beginning  with  this  chapter  a  brief 
discussion  of  the  different  phases  of  the  law  of  contracts  will  be  given. 

Essential  Conditions.  Before  an  agreement  partakes  of 
the  nature  of  a  contract  and  becomes  legally  enforceable,  there 
must  be  certain  conditions  adhered  to.  The  agreement  must 
be  between  two  or  more  COMPETENT  parties,  based  upon 
SUFFICIENT  consideration,  to  do  or  not  to  do  some  LAWFUL, 
POSSIBLE  thing.  The  agreement  must  be  mutual,  that  is, 
the  minds  of  the  parties  must  have  met.  It  will  be  seen,  there- 
fore, that  there  are  four  essentials  to  every  contract: 

1.  Competent  parties. 

2.  Mutual  agreement. 

3.  Sufficient  consideration. 

4.  Legal  subject  matter. 

Methods  of  Making  Contracts.  There  are  but  two 
ways  of  creating  a  contract.  One  is  by  a  WRITTEN  AGREE- 
MENT and  the  other  is  by  an  ORAL  UNDERSTANDING 
between  the  parties.  Undoubtedly  the  most  important  thing 
to  set  forth  in  this  lesson  is  that  it  is  always  best  to  make  a 
written  contract.  A  written  contract  may  be  under  SEAL  or 
may  be  a  SIMPLE  contract. 

An  oral  contract  may  be  either  EXPRESSED  or  IMPLIED. 
It  is  expressed  when  its  terms  are  stated  and  agreed  to  by  the 
parties.  It  is  implied  when  its  terms  are  inferred  from  the 
acts  of  the  parties.  A  great  many  contracts  are  implied.  For 
instance,  if  one  calls  in  a  physician  in  case  of  illness,  it  is  under- 
stood that  he  expects  to  pay  for  the  service  whether  he  says 
anything  about  it  or  not.  The  same  is  true  when  one  orders 
groceries  delivered  at  his  home  without  reference  to  payment. 

Certain  Contracts  Must  be  in  Writing.  The  Statute 
of  Frauds  requires  that  certain  contracts  must  be  in  writing, 
or  at  least  there  must  be  a  memorandum  in  writing.  This 
statute  has  been  adopted  by  nearly  all  the  states  and  it  is  prac- 
tically uniform. 

Documents  of  greater  importance  must  usually  be  made 
under  seal.  The  state  statutes  cover  this  and,  as  they  differ 
to  some  extent,  it  would  be  best  to  become  familiar  with  the 
statutes  covering  this  point  in  your  state. 

Contracts  not  made  under  seal  are  said  to  be  CONTRACTS 
BY  PAROL,  or  simple  contracts.  They  may  be  either  oral  or 
written. 


30  PUBLIC  ACCOUNTING  AND  AUDITING 

A.    THEORY  QUESTIONS 

1 .  Distinguish  between  a  Balance  Sheet  audit  and  a  detailed 
audit.  C.  P.  A.  Ohio. 

2.  Large  business  concerns  frequently  have  on  their  staff 
what  are  known  as  "internal  auditors".     Under  such  conditions, 
would   you   approve   the   employment   of  Certified  Public  Ac- 
countants to  make  periodical  audits?     Give  reasons  for  your 
answer.  C.  P.  A.  Ind. 

3.  Under  what  circumstances  would  you  advise  a  client 
that  a  complete  detailed  audit  should  be  made?     Give  your 
arguments  to  convince  him  that  a  test  audit  would  not  be  sat- 
isfactory. C.  P.  A.  111. 

4.  How  is  the  position  of  an  auditor  affected  if  the  system 
of  the  concern  under  audit  is  defective  as  to  internal  check? 

Inst.  Ex.  1918. 

5.  Why  is  it  advisable  to  determine  the  legal  responsi- 
bility of  a  client  before  accepting  an  engagement? 

6.  What  do  you  understand  by  (a)  personal  account,  (b) 
impersonal  account,  (c)  real  account,  (d)  nominal  account? 

C.  P.  A.  Ind. 

7.  Define  the  following: 

(a)  Fixed  assets  and  fixed  liabilities. 

(b)  Current  assets  and  current  liabilities. 

C.  P.  A.  Mich. 

8.  In  making  "detailed"  audits  some  auditors  verify  all 
postings  and  footings  of  general  and  subsidiary  ledgers,  even 
though  controlling  accounts  are  kept.     State  reasons  for  and 
against  such  procedure.  Inst.  Ex.  1919. 

B.    ACCOUNTING  PROBLEMS 

i.     The  Trial  Balance  of  the  Yellow  Pine  Timber  Co.  on 
January  I,  1920,  was  as  follows: 

Cash $      2,618.03 

Accounts  Receivable 21,111.17 

Inventory 36,133-32 

Unexpired  Insurance 559-44 

Plant  and  Equipment 352,109.75 

Timber  and  Lands 551, 539.31 

Preferred  Claims $     37,011.99 

First  Mortgage  Bonds,  6s.  ...  212,500.00 

Bond  Interest  Accrued 4,533-24 

Unsecured  Creditors 64,471.64 

Capital  Stock 400,000.00 

Surplus 245,554.15 


,071.02          $964,071.02 


ACCOUNTING  PROBLEMS  31 

Classify  the  accounts  in  accordance  with  the  outline 
shown  on  page  26.  C.  P.  A.  N.  Y. 

(Note.  The  date  of  this  Trial  Balance  is  January  I,  1920,  hence  all 
nominal  accounts  have  been  closed  into  surplus.  All  accounts  appearing  in 
the  Trial  Balance  are  real  accounts,  but  they  should  be  classified,  showing 
which  are  personal  and  which  are  impersonal  with  a  further  subdivision 
into  assets — current  and  fixed;  and  liabilities — current  and  fixed.) 

2.  The  office  of  a  firm  of  traders,  doing  business  in  San 
Francisco  was  destroyed  by  an  earthquake.  The  books  of 
account,  which  had  been  fully  posted,  were  badly  damaged. 
The  following  ledger  accounts  were  found  to  be  legible:  Pur- 
chases, net,  $69,000;  Discounts  Lost,  $640;  Discounts  Gained, 
$3,450;  Sales,  $54,000;  Bills  Receivable,  $33,000. 

Inquiry  at  the  bank  disclosed  a  balance  on  deposit,  $129,000. 
Bills  receivable  amounting  to  $45,000  had  been  discounted  at 
the  bank.  An  audit  of  the  checks  paid  by  the  bank  showed 
that  $99,000  had  been  paid  creditors  (including  $60,000  notes 
payable). 

A  Balance  Sheet  prepared  at  the  last  closing  of  the  books 
was  produced,  containing  the  following  items:  cash,  $60,000; 
accounts  receivable,  $126,000;  loans  receivable,  $24,000;  real 
estate,  $90,000;  notes  receivable,  $78,000;  capital,  $318,000; 
notes  payable,  $60,000. 

Prepare  a  Trial  Balance  supplying  the  missing  accounts. 

C.  P.  A.  N.  Y. 

(Note.  You  should  set  up  skeleton  ledger  accounts  with  Real  Estate, 
Cash,  Notes  Receivable,  Loans  Receivable,  Accounts  Receivable,  Accounts 
Payable,  Capital,  Sales,  Purchases,  Discounts  Gained,  and  Discounts  Lost. 

1 .  Debit  or  credit  each  account  with  the  amount  shown  in  the  Balance 
Sheet  prepared  at  the  last  closing  of  the  books. 

2.  Set  up  the  balances  of  those  ledger  accounts  which  were  found  to 
be  legible  after  the  earthquake. 

3.  Make  the  necessary  adjusting  entries  from  the  information  obtained 
at  the  bank  and  from  an  audit  of  the  checks  paid  by  the  bank. 

After  this  work  has  been  completed,  you  will  have  no  difficulty  in  pre- 
paring a  Trial  Balance.) 

3.  From  the  Trial  Balance  prepared  in  the  solution  of 
Problem  No.  2,  you  may  prepare  a  list  of  the  assets  and  lia- 
bilities. List  the  current  assets  first  and  the  fixed  assets  second. 
Likewise,  list  the  current  liabilities  first  and  the  capital  second. 
Show  the  amount  of  increase  or  decrease  in  the  net  worth  of 
the  business. 

(Note.  You  may  assume  that  the  entire  stock  of  merchandise  was 
destroyed  by  fire  following  the  earthquake.) 


32  PUBLIC  ACCOUNTING  AND  AUDITING 

C.     LEGAL  QUESTIONS 

1.  What  are  the  essential  elements  to  every  valid  contract? 

C.  P.  A.  Mich. 

2.  What  special  element  is  required  in  some  contracts  but 
not  in  all?  C.  P.  A.  Ohio. 

3.  How  is  a  contract  made?  C.  P.  A.  N.  Y. 

4.  Can  a  contract  be  implied?  C.  P.  A.  Mich. 

5.  Where  a  contract  is  in  writing  is  it  admissable  for  one 
of  the  parties  to  it,  to  vary  it  by  proving  that  at  the  time  it 
was  entered  into,  such  was  their  oral  agreement?        C.  P.  A.  111. 


Chapter  Three 

Books  of  Account.  Before  proceeding  with  a  Balance 
Sheet  audit,  the  auditor  must  thoroughly  understand  the  various 
systems  of  account  in  general  use  and  be  familiar  with  all  books 
of  account,  both  those  of  original  entry,  including  AUXILIARY 
books,  and  those  of  final  entry,  including  SUBSIDIARY  books. 
By  auxiliary  books  is  meant  those  which  contain  detailed  in- 
formation supporting  the  record  in  the  books  of  original  entry. 
They  include  check  stubs,  note  stubs,  draft  stubs,  receipt  stubs, 
bank  pass  books,  etc. 

By  subsidiary  books  are  meant  subsidiary  ledgers  controlled 
by  accounts  in  the  general  ledger.  They  include  customers' 
ledgers,  creditors'  ledgers,  stockholders'  ledgers,  cost  ledgers, 
etc. 

The  following  discussion  and  the  accompanying  chart  is 
intended  as  a  review  of  the  ordinary  principles  of  bookkeeping 
and  accounting  as  taught  in  the  leading  texts. 


BOOKS  OF  ORIGINAL  ENTRY 

The  Journal.  It  is  possible  to  record  all  transactions  in 
what  is  known  as  a  general  journal  and,  regardless  of  how  many 
subdivisions  of  this  journal  there  may  be  in  a  system  of  accounts, 
all  books  of  original  entry  which  are  used  as  a  posting  media 
constitute  a  part  of  the  journal.  James  W.  Baker,  in  his  "2Oth 
Century  Bookkeeping  and  Accounting",  says: 

t 

"The  Journal  is  a  book  of  original  entry  in  which  all 
the  transactions  may  be  recorded.  If  it  is  the  only  book  of 
original  entry,  all  the  transactions  are  recorded  in  it;  if  the 
purchases,  sales,  cash  receipts,  and  cash  payments  are  re- 
corded in  special  books,  it  contains  only  those  transactions 
not  recorded  in  these  books.  The  record  shows  the  date, 
name  of  the  account  debited  and  amount,  name  of  the  ac- 
count credited  and  amount,  and  the  explanation  or  infor- 
mation for  the  auditor." 

33 


34  PUBLIC  ACCOUNTING  AND  AUDITING 

Roy  B.  Kester,  C.  P.  A.,  in  his  "Accounting,  Theory  and 
Practice,"  says: 

"A  Journal  may  be  denned  as  a  diary  or  log  in  which 
the  happenings  or  transactions  of  a  business  are  recorded. 
Formerly  it  was  sometimes  called  a  day-book  or  blotter. 
The  day-book  or  blotter  record  was  a  rough  record  giving 
all  the  essential  data  relating  to  each  transaction  without 
regard  to  accounting  terminology,  and  was  used  as  a  sort  of 
memorandum  from  which  a  formal  record  might  be  made 
in  accounting  terminology.  This  day-book  or  blotter,  still 
in  use  in  some  places,  has  very  largely  given  place  to  the 
journal  which,  either  a  single  book  or  separated  into  many 
subsidiary  books,  is  the  book  of  original  entry." 

Reference  to  the  illustration  on  page  35  will  show  how  the 
journal  might  be  subdivided  in  a  highly  organized  system  of 
accounts.  Under  such  a  subdivision,  it  will  be  seen  that  trans- 
actions of  a  similar  nature  are  recorded  in  separate  books.  The 
saving  of  time  in  posting  is  evident  although  it  is  not  the  only 
reason  for  such  a  subdivision  of  the  journal.  Another  reason 
is  the  fact  that  it  enables  several  bookkeepers  to  record 
entries  in  the  original  books  at  the  same  time,  where  if  only  one 
or  a  few  books  of  original  entry  were  in  use,  the  volume  of 
business  might  be  so  great  that  the  bookkeepers  could  not 
handle  the  work. 

Therefore,  in  planning  a  system  of  accounts,  it  is  always 
necessary  to  provide  special  records  or  books  for  recording  each 
class  of  transactions  in  accordance  with  the  volume  and  nature 
of  the  business,  and  depending  upon  the  number  of  employees 
involved  in  recording  the  transactions. 

Regardless  of  the  detailed  subdivision  of  the  journal,  there 
will  still  remain  certain  transactions  that  should  be  recorded  in 
the  general  journal.  A.  Lowes  Dickinson,  C.  P.  A.,  in  his  "Ac- 
counting Practice  and  Procedure,*"  says: 

"A  journal  is,  however,  still  necessary  for  special  en- 
tries, correction  entries,  and  other  miscellaneous  matters 
which  do  not  fall  within  the  scope  of  any  of  the  books  or 
forms  described." 

The  principal  use  for  the  general  journal  will  be  for  record- 
ing opening  entries  at  the  beginning  of  the  business,  correction 
entries  during  the  fiscal  period,  and  adjusting  and  closing  entries 
at  the  end  of  the  fiscal  period.  Of  course,  any  special  entries 
that  cannot  properly  be  classified  in  the  special  journals  will  be 
recorded  in  the  general  journal. 

BOOKS  OF  FINAL  ENTRY 

If  the  journal  is  to  be  subdivided  into  special  books  for  the 
sake  of  saving  time,  for  analyzing  purposes,  and  to  enable  more 
bookkeepers  to  work  on  them  at  the  same  time,  likewise,  it  is 
equally  advisable  to  subdivide  the  ledger. 

'Published  by  Ronald  Press  Co. 


BOOKS  OF  ACCOUNT 


35 


S/'s    /  i  NN\S^NV 

x     x      /       /  ,  \      \      V    N 

X   /     /        I  \  \ 

'        /         I  I  \ 


X 


\       \      \ 
\       \       N 

\     \  N- 

\  \          \ 


\ 


\ 


X                 /                  I                    1                   \                  v                v               N^ 

• 

• 

Sales 
Returns 
Book 

Notes 
Recoivabl 
Book 

Cash 
Receipts 
Book 

Purchase 
Book 

General 
Journal 

03        tA 

o      o 

r-t          0 

oJ      PQ 

CO 

Cash 
Payments 
Book 

<D  f>    O 

•^  C3  0 
O   >>CQ 

Purchase: 
Returns 
Book 

36  PUBLIC  ACCOUNTING  AND  AUDITING 

The  Ledger.  If  only  a  general  ledger  were  maintained  in  a 
large  firm,  where  there  may  be  thousands  of  accounts,  one  can 
readily  see  that  no  bookkeeper  could  possibly  keep  up  with  the 
volume  of  work,  unless  some  sort  of  a  card  or  loose-leaf  ledger 
were  used  enabling  different  persons  to  post  at  the  same  time. 
Hence  it  not  only  becomes  advisable,  but  absolutely  necessary, 
to  subdivide  the  ledger.  The  process  in  subdividing  the  ledger, 
however,  differs  from  the  subdivisions  of  the  journal  in  this 
respect,  that  the  general  ledger  controls  all  accounts  which  are 
kept  in  what  are  known  as  subsidiary  ledgers. 

Subsidiary  Ledgers.  In  an  ordinary  mercantile  business, 
the  principal  subsidiary  ledgers  are  the  sales  and  purchases 
ledgers.  From  the  standpoint  of  terminology,  a  number  of  dif- 
ferent names  have  been  applied  to  these  ledgers.  Accounts  re- 
ceivable ledger,  sales  ledger,  customers'  ledger  and  debtors'  ledger 
are  all  synonymous  terms  and  mean  the  same  thing.  Likewise, 
purchases  ledger,  accounts  payable  ledger  and  creditors'  ledger 
are  synonymous  terms.  Other  terms  are  also  used,  for  instance, 
a  sales  ledger  may  be  arranged  so  as  to  show  accounts  with  cus- 
tomers in  either  alphabetical,  geographical  or  numerical  order. 
In  the  event  that  they  are  arranged  in  alphabetical  order,  then 
there  may  be  one  or  more  ledgers  with  controlling  accounts 
for  each.  The  controlling  account  might  be  named  A  to  C 
Ledger,  D  to  E  Ledger,  etc.  If  the  arrangement  is  geogra- 
phical, the  ledgers  might  be  known  as  city  ledgers,  coun- 
try ledgers,  foreign  ledgers,  state  ledgers,  etc.  Furthermore, 
the  ledgers  may  be  in  the  form  of  bound  books,  loose  leaf  books, 
cards  or  vouchers.  One  will  frequently  find  a  system  of  arrang- 
ing the  accounts  numerically,  in  which  case  the  bookkeeper  in 
charge  of  a  customers'  ledger  may  not  know  who  the  customers 
are  as  he  does  his  posting  from  information  in  memorandum 
form,  the  name  of  the  account  being  represented  by  numbers 
only.  Experience  only  will  enable  one  to  become  familiar  with 
all  the  different  methods  and  plans  used. 

Controlling  Accounts.  A  controlling  account  for  each  sub- 
sidiary ledger  will  be  kept  in  the  general  ledger,  and  this  con- 
trolling account  will  show  at  all  times  the  exact  status  of  the 
subsidiary  ledger.  By  means  of  controlling  accounts  for  the 
subsidiary  ledgers,  the  general  bookkeeper  keeps  his  ledger  in 
balance  at  all  times  without  the  necessity  of  preparing  schedules 
of  the  accounts  in  the  subsidiary  ledgers. 

W.  A.  Paton,*  Ph.  D.,  and  R.  A.  Stevenson.f  Ph.  D.,  in 
their  text  on  Principles  of  Accounting,  say: 

"The  possibility  for  labor  saving  is  often  dependent 
upon  the  use  of  controlling  accounts  and  subsidiary  ledgers. 
The  total  amount  receivable  on  customers'  accounts  con- 
stitutes one  distinct  asset  item  for  Balance  Sheet  purposes. 

*Assistant  Professor  of  Economics  in  the  University  of  Michigan. 
fAssociate  Professor  of  Accounting  in  the  University  of  Iowa. 


THE  TRIAL  BALANCE  37 

The  amount  due  from  an  individual  customer  is  of  little 
importance  in  the  presentation  of  a  statement  showing  a 
firm's  financial  condition.  It  is  the  summary  of  all  the 
customers'  accounts  that  is  significant.  It  is  obvious  that 
for  other  purposes,  however,  a  knowledge  of  the  amount 
due  from  individual  customers  must  be  available.  In  order  to 
serve  both  of  these  purposes  the  controlling  account  is  used." 

The  chart  also  shows  that  if  the  business  is  a  manufacturing 
business  and  it  is  desired  to  maintain  a  cost  system,  a  sepa- 
rate factory  cost  ledger  may  be  kept,  but  that  this  will  be  con- 
trolled by  an  account  in  the  general  ledger  just  the  same  as  a 
subsidiary  ledger  with  customers  or  creditors  would  be  kept. 
At  this  point  the  system  becomes  still  more  complicated  by  the 
fact  that  the  number  of  transactions  affecting  the  cost  ledger  are 
so  great  that  it  may  be  necessary  to  subdivide  that  ledger  and 
maintain  subsidiary  cost  ledgers  for  special  cost  accounts.  For 
instancfe,  a  separate  ledger  might  be  kept  with  manufactured 
parts  and  another  with  raw  material. 

THE  TRIAL  BALANCE 

In  preparing  a  Trial  Balance  from  the  general  ledger,  it  will 
not  be  necessary  to  take  into  consideration  any  of  the  subsidiary 
ledgers  unless  it  is  desired  to  check  the  controlling  accounts  with 
the  sum  of  the  balances  of  the  accounts  in  the  subsidiary  ledgers. 
This  must  be  done  at  the  end  of  each  fiscal  period.  In  most 
cases  it  is  advisable  to  make  this  check  at  least  once  a  month. 
The  professional  auditor,  however,  will  never  accept  a  Trial 
Balance  from  the  general  ledger  without  preparing  schedules 
from  all  the  subsidiary  ledgers  and  making  a  careful  comparison 
with  the  controlling  account  in  the  general  ledger. 

The  accounts  should  be  so  arranged  in  the  ledger  that  they 
will  be  in  proper  order  for  the  preparation  of  the  statements  at 
the  end  of  the  period.  The  arrangement  of  the  accounts  in  the 
Trial  Balance  is  not  a  matter  of  great  importance ;  however,  the 
Trial  Balance  is  usually  prepared  by  following  the  ledger,  page 
by  page.  Whatever  arrangement  or  classification  of  accounts 
has  been  carried  out  in  the  ledger,  therefore,  will  be  duplicated 
in  the  Trial  Balance.  If  the  accounts  have  been  properly  ar- 
ranged in  the  ledger,  the  Trial  Balance  will,  therefore,  show  the 
accounts  arranged  in  such  a  manner  that  it  will  be  an  aid  in  pre- 
paring the  financial  statements. 

Too  many  bookkeepers  consider  the  Trial  Balance  as  an 
indication  of  the  correctness  of  their  work.  This  frequently 
leads  to  trouble  because  a  Trial  Balance,  even  though  it  is  in 
balance,  will  not  indicate  or  detect  errors  in  principle,  off-setting 
errors  or  errors  of  omission.  The  fact  is,  a  Trial  Balance  is  noth- 
ing more  than  a  fairly  reliable  indication  of  accuracy,  and  simply 
shows  the  equilibrium  or  equality  of  debits  and  credits.  Another 
form  of  the  Trial  Balance  used  by  accountants,  known  as  the 
Working  Sheet,  will  be  discussed  later. 


47117 


38  PUBLIC  ACCOUNTING  AND  AUDITING 

THE  BALANCE  SHEET 

It  has  already  been  stated  that  the  accounts  in  the  ledger 
should  be  so  arranged  as  to  make  it  convenient  to  prepare  a  Bal- 
ance Sheet.  At  this  point,  the  proper  arrangement  of  accounts 
in  the  Balance  Sheet  will  be  taken  up.  Conflicting  theories  exist. 

First;  Accountants  in  England  and  America  do  not  agree 
with  reference  to  the  listing  of  the  assets  on  the  debit  side  of 
the  Balance  Sheet  and  the  liabilities  on  the  credit  side.  English 
accountants  hold  that  a  Balance  Sheet  is  an  account  rendered 
by  the  business  to  the  owner;  therefore,  the  proprietor  is  cred- 
ited with  his  assets  and  debited  with  his  liabilities.  Hence  the 
Balance  Sheet  shows  the  liabilities  on  the  debit  side  and  the 
assets  on  the  credit  side.  This  is  just  the  reverse  of  the  prac- 
tice by  American  accountants  who  hold  that  a  Balance  Sheet  is 
a  concrete  preparation  of  financial  facts,  the  debit  side  of  the 
Balance  Sheet  showing  the  assets  and  the  credit  side,  the  liabil- 
ities. 

Second;  American  accountants  have  not  been  able  to  agree 
as  to  the  arrangement  of  the  assets  and  liabilities  on  the  Balance 
Sheet.  Some  list  (a)  the  fixed  assets  on  the  debit  side  opposed 
to  the  fixed  liabilities  on  the  credit  side,  (b)  the  current  assets 
on  the  debit  side  opposed  to  the  current  liabilities  on  the  credit 
side,  and  (c)  the  deferred  debit  items  opposed  to  the  deferred 
credit  items,  while  others  arrange  the  assets  and  liabilities 
without  regard  to  any  particular  classification.  Some  show 
the  capital  or  proprietorship  accounts  first  on  the  credit 
side,  while  others  show  them  last.  Some  show  reserves  as  de- 
ductions from  assets.  Others  show  them  either  as  liabilities 
or  as  a  part  of  the  proprietorship  section.  Regardless  of  all  this 
difference  in  opinion,  there  is  gradually  coming  about  a  uni- 
formity, and  it  is  to  be  encouraged  at  all  times. 

Robert  H.  Montgomery,*  C.  P.  A.,  expresses  his  conception 
of  an  ideal  Balance  Sheet  as  one  which  will  set  forth: 

1.  "The  assets,  properly  valued  and  grouped,  and  ar- 
ranged in  the  order  of  their  availability. 

2.  "The  liabilities  also  properly  grouped  and  arranged 
in  the  order  they  will,  or  should,  be  discharged. 

3.  "If  possible  the  excess  of  the  assets  or  the  liabilities 
should  now  be  shown  in  order  that  there  may  be  clearly 
apparent  to  anyone  interested,  the  net  worth,  or  capital 
and  surplus,  of  the  enterprise. 

4.  "A  statement  showing  to  whom  the  excess  belongs 
or  by  whom  it  is  due.     That  is,'  if  a  corporation,  there 
should  be  shown   the  capital   stock  issued,   the  addition 
thereto  if  a  surplus  of  assets  exists,  or  the  deduction  there- 
from if  there  is  a  deficiency." 

A  Model  Balance  Sheet.  The  Model  Balance  Sheet 
illustrated  on  pages  40  and  41  shows  the  arrangement  of  the 
different  classes  of  real  accounts  in  accordance  with  a  tentative 


*Of  the  firm  of  Price,  Waterhouse  &  Company. 


THE  BALAN7CE  SHEET  39 

proposal  for  a  uniform  system  of  accounting  to  be  adopted 
by  manufacturing  and  merchandising  concerns.  The  proposal 
was  made  in  1917  by  the  Federal  Reserve  Board  and  is  the  out 
growth  of  the  work  of  the  Federal  Trade  Commission  and  of  Mr. 
Edward  N.  Hurley,  in  particular,  who  during  his  entire  term 
of  office  labored  zealously  and  intelligently  for  the  betterment  of 
business  and  credit  conditions. 

The  Federal  Reserve  Board  in  prescribing  a  uniform  Bal- 
ance Sheet  to  be  used  for  credit  purposes  has  performed  a  real 
service  in  promoting  uniform  accounting. 

In  commenting  on  the  model  Balance  Sheet  prescribed,  at- 
tention should  be  called  to  the  fact  that  it  would  have  been 
better  to  separate  notes  and  accounts  receivable  so  as  to  allow 
a  separate  deduction  for  a  reserve  for  bad  debts  from  each. 
The  percentage  of  loss  will  not  be  so  great  on  notes  as  on  open 
accounts,  therefore,  the  percentage  set  up  as  reserves  will  vary. 

Note  that  securities  are  excluded  from  the  list  of  "quick" 
assets,  but  included  in  the  list  of  current  assets.  This  is  in  ac- 
cordance with  Federal  Reserve  practice,  but  ordinarily  no  dis- 
tinction is  made  between  quick  and  current  assets. 

No  provision  for  accrued  assets  is  made.  In  practically 
every  audit,  there  will  be  a  certain  amount  of  accrued  assets. 
These  should  always  be  listed  among  the  current  assets  and  in 
using  the  form  of  Balance  Sheet  as  advocated  by  the  Federal 
Reserve  Board,  it  is  apparent  that  accrued  assets  would  be  listed 
under  the  heading  of  "Other  quick  assets."  Since  provision 
was  made  for  accrued  liabilities  on  the  credit  side,  one  is  inclined 
to  think  that  similar  provision  should  have  been  made  for  ac- 
crued assets  on  the  debit  side. 

The  accounting  student  might  easily  be  misled  from  the 
fact  that  fixed  assets  are  all  grouped  together,  followed  by  re- 
serves for  depreciation.  It  was  undoubtedly  the  intention  that 
the  reserves  for  depreciation  should  be  deducted  from  the  par- 
ticular fixed  asset  to  which  they  are  applicable.  For  instance, 
a  reserve  for  depreciation  on  machinery  is  a  deduction  from  the 
Machinery  account  on  the  Balance  Sheet  and  not  from  the  total 
fixed  assets,  even  though  the  final  results  would  be  the  same. 
Likewise,  reserves  for  depreciation  on  buildings  should  be  de- 
ducted from  the  asset,  buildings.  Reserve  for  depreciation  on 
office  furniture  and  fixture  should  be  deducted  from  the  asset, 
furniture  and  fixtures,  and  so  on. 

On  the  credit  side  of  the  Balance  Sheet,  there  is  to  be  noted 
a  peculiar  difference  from  the  usual  practice.  The  intangible 
asset,  good  will,  is  deducted  from  the  net  worth.  It  has  been 
customary  to  list  good  will  and  other  similar  intangible  assets 
on  the  asset  side  of  the  Balance  Sheet  separate  from  either  cur- 
rent or  fixed  assets,  usually  at  the  bottom  of  the  statement. 
While  the  final  results  are  the  same  with  either  method,  yet 
there  is  no  doubting  the  fact  that  certain  intangible  assets,  such 
as  good  will,  may  have  a  definite  value,  and  in  that  event  one 
can  see  no  objection  to  their  being  listed  as  assets. 


PUBLIC  ACCOUNTING  AND  AUDITING 


ASSETS. 
Cash: 

I  a.  Cash  on  hand — currency  and  coin xxxxx.  xx 

ib.  Cash  in  bank xxxxx.  xx    xxxxx. xx 

Notes  and  Accounts  Receivable: 

3.     Notes  receivable  of  customers  on  hand  (not  past 

due) xxxxx. xx 

5.     Notes  receivable  discounted  or  sold  with  in- 
dorsement or  guaranty xxxxx. xx 

7.     Accounts  receivable,  customers  (not  past  due),     xxxxx. xx 
9.     Notes  receivable,   customers,   past  due    (cash 

value,  $xx) 

1 1 .     Accounts  receivable,  customers,  past  due  (cash 

value,  #xxxx) xxxxx. xx 

Less :  xxxxx . xx 

13.     Provisions  for  bad  debts xxxxx. xx 

15.     Provisions   for   discounts,    freights, 

allowances,  etc xxxxx.  xx    xxxxx. xx    xxxxx. xx 

Inventories : 

17.     Raw  material  on  hand xxxxx. xx 

19.     Goods  in  process xxxxx.  xx 

21.     Uncompleted  contracts xxxxx. xx 

Less  payments  on  account  thereof. .     xxxxx. xx 

xxxxx. xx 
23.     Finished  goods  on  hand xxxxx. xx    xxxxx. xx 

Other  Quick  Assets  (describe  fully) : 

xxxxx. xx 

xxxxx . xx  xxxxx . xx 

XXXXX.  XX 

Total  quick  assets  (excluding  all  investments) . 

Securities: 

25.     Securities  readily  marketable  and  salable  with- 
out impairing  the  business xxxxx.  xx 

27.     Notes  given  by  officers,  stockholders,  or  em- 
ployees      xxxxx. xx 

29.     Accounts  due  from  officers,  stockholders,  or  em- 

ploj'ees xxxxx.  xx     xxxxx.  xx 

Total  current  assets xxxxx. xx 

Fixed  Assets: 

31.     Land  used  for  plant xxxxx. xx 

33.     Buildings  used  for  plant xxxxx. xx 

35.     Machinery xxxxx.  xx 

37.     Tools  and  plant  equipment xxxxx.  xx 

39.     Patterns  and  drawings xxxxx. xx 

41.     Office  furniture  and  fixtures xxxxx.  xx 

43.     Other  fixed  assets,  if  any  (describe  fully) xxxxx.  xx 

xxxxx . xx 

XXXXX. XX 

Less: 

45.     Reserves  for  depreciation xxxxx. xx 

Total  fixed  assets xxxxx. xx 

Deferred  Charges: 

47.     Prepaid  expenses,  interest,  insurance,  taxes,  etc.     xxxxx.  xx    xxxxx.  xx 

Other  assets  (49) xxxxx.  xx     xxxxx .  xx 

Total  assets xxxxx. xx 

(Model  Balance  Sheet  for  credit  purposes.) 


THE  BALANCE  SHEET 


LIABILITIES. 


Notes  and  Accounts  Payable: 
Unsecured  Notes — 

2.     Acceptances  made  for  merchandise  or  raw  ma- 
terial purchased xxxxx.  xx 

4.     Notes  given  for  merchandise  or  raw  material 

purchased xxxxx.  xx 

6.     Notes  given  to  banks  for  money  borrowed xxxxx.  xx 

8.     Notes  sold  through  brokers xxxxx. xx 

10.     Notes  given  for  machinery,  additions  to  plant, 

etc xxxxx.  xx 

12.     Notes  due  to  stockholders,  officers,  or  employees    xxxxx.  xx     xxxxx.  xx 

Unsecured  Accounts: 

14.     Accounts  payable  for  purchases  (not  yet  due).,     xxxxx. xx 

16.     Accounts  payable  for  purchases  (past  due) xxxxx. xx 

1 8.     Accounts  payable  to  stockholders,  officers,  or 

employees xxxxx.  xx     xxxxx.  xx 

Secured  Liabilities: 

2Oa.  Notes  receivable  discounted  or  sold  with  in- 
dorsement or  guaranty  (contra) xxxxx.  xx 

2ob.  Customers'  accounts  discounted  or  assigned 

(contra) xxxxx.  xx 

20c.  Obligations  secured  by  liens  on  inventories. .  . .     xxxxx. xx 

2od.  Obligations  secured  by  securities  deposited  as 

collateral xxxxx.  xx  xxxxx.  xx 

22.     Accrued  liabilities  (interest,  taxes,  wages,  etc.)     xxxxx. xx    xxxxx. xx 

Other  Current  Liabilities  (describe  fully) : 

xxxxx. xx 

XXXXX .  XX   XXXXX .  XX 

Total  current  liabilities xxxxx. xx 

Fixed  Liabilities: 

24.     Mortgage  on  plant  (due  date) xxxxx. xx 

26.     Mortgage  on  other  real  estate  (due  date) xxxxx.  xx 

28.     Chattel  mortgage  on  machinery  or  equipment 

(due  date) xxxxx .  xx 

30.     Bonded  debt  (due  date) xxxxx .  xx     xxxxx. xx 

32.     Other  fixed  liabilities  (describe  fully): 

xxxxx . xx 

XXXXX . XX   XXXXX . XX 

Total  liabilities xxxxx.xx      xxxxx. xx 

Net  Worth: 

34.     If  a  corporation — 

(a)  Preferred  stock  (less  stock  in  treasury). .      xxxxx.xx 

(b)  Common  stock  (less  stock  in  treasury)...      xxxxx.xx 

(c)  Surplus  and  undivided  profits xxxxx .  xx 

xxxxx.xx 
Less: 

(d)  Book  value  of  good  will xxxxx.  xx 

(e)  Deficit xxxxx . xx     xxxxx . xx     xxxxx.xx 

36.     If  an  individual  or  partnership — 

(a)Capital xxxxx.xx 

(b)  Undistributed  profits  or  deficit xxxxx .  xx    

Total  Liabilities  and  Net  Worth xxxxx. xx 

(Model  Balance  Sheet  for  credit  purposes.) 


42  PUBLIC  ACCOUNTING  AND  AUDITING 

THE  FOLLOWING  DISCUSSION  OF  THE  BALANCE 
SHEET  IS  BY  JAMES  O.  McKINSEY,  C.  P.  A.* 
"The  Purpose  of  the  Balance  Sheet  is  to  make  the 
financial  facts  in  regard  to  the  business  COMPREHENSIBLE 
to  the  proprietor  and  others.  This  idea  cannot  be  emphasized 
too  strongly,  not  only  in  regard  to  the  Balance  Sheet,  but  also 
in  reference  to  all  the  other  financial  statements.  It  should  be 
remembered  that  they  are  prepared  primarily  for  the  proprietor 
or  creditors  of  the  business,  and  many  of  them  have  no  techni- 
cal training  in  accounting.  These  statements  should  be  in  such 
a  form  that  they  can  be  readily  understood  by  those  for  whom 
they  are  intended.  Mr.  Montgomery  says:  'Many  intelligent 
people  fail  to  grasp  the  usual  conventional  hypothesis  under- 
lying the  theory  of  double  entry  bookkeeping,  and,  therefore, 
facts  or  figures  presented  to  them  in  a  technical  or  formal  shape 
may  not  accomplish  the  intended  result^ 

Balance  Sheet  vs.  Financial  Statement.  "Prob- 
ably one  of  the  first  questions  which  arise  in  the  mind  of 
some  readers  is  in  reference  to  the  propriety  of  the  term 
'Balance  Sheet'.  The  writer  is  well  aware  that  this  term  is 
not  generally  used  in  elementary  accounting  texts.  The  term 
'financial  statement'  seems  to  be  a  favorite  one  with  most  text 
writers,  although  the  terms  'statement  of  resources  and  liabili- 
ties,' 'statement  of  assets  and  liabilities',  and  'business  statement' 
are  sometimes  used.  A  financial  statement  is  any  statement 
of  financial  facts.  The  Balance  Sheet  is  a  financial  statement, 
but  so  is  a  Profit  and  Loss  statement,  a  statement  of  Affairs, 
or  a  statement  of  Receipts  and  Expenditures,  as  well  as  many 
others  which  might  be  added.  To  call  this  particular  statement 
a  financial  statement  does  not  differentiate  it  from  many  other 
such  statements.  In  reference  to  the  other  terms  mentioned, 
it  is  sufficient  to  say  that  they  are  rarely  used  by  accountants, 
and  when  they  are  used,  they  are  employed  for  a  special  purpose 
and  not  in  reference  to  the  statement  which  is  defined  as 
a  Balance  Sheet  above.  The  writer  has  had  occasion  to  examine 
numerous  reports  made  by  accountants  of  the  highest  rank,  in 
three  different  large  cities,  during  the  last  two  years  and  he  has 
never  seen  any  term  but  Balance  Sheet  used  in  the  above  con- 
nection. 

"As  stated  above,  the  purpose  of  the  Balance  Sheet  is  to 
set  forth  the  financial  condition  of  the  business.  This  statement 
might  be  criticised  on  the  ground  that  the  true  and  complete 
financial  condition  is  not  shown  unless  the  Balance  Sheet  is 
accompanied  by  the  statement  of  Profit  and  Loss.  In  other 
words,  it  is  impossible  to  intelligently  judge  of  the  present  con- 
dition unless  the  causes  of  that  condition  and  thereby  some 
indication  of  the  possibilities  of  the  future  are  known.  Leaving 

*  Instructor  of  Accounting  at  the  University  of  Chicago.  Author 
of  "Bookkeeping  and  Accounting,"  published  by  South-Western  Publishing 
Company. 


THE  BALANCE  SHEET  43 

aside  this  question  for  the  present,  it  can  be  readily  seen  that 
the  Balance  Sheet  should  show  three  things: 

1.  The  amount  and  nature  of  the  assets. 

2.  The  amount  and  nature  of  the  liabilities. 

3.  The  amount  and  nature  of  the  differences  between  the 
assets  and  liabilities,  which  constitutes  the  interest  of  the  pro- 
prietor. 

"In  order  that  this  may  be  done  satisfactorily,  it  is  neces- 
sary that  the  accounting  records  be  properly  kept,  so  that  the 
desired  information  may  be  obtained.  This,  of  course,  involves 
all  the  principles  governing  the  proper  construction  of  the  differ- 
ent accounts.  Assuming  that  the  accounts  are  properly  kept, 
the  following  will  be  confined  to  a  brief  discussion  of  the  arrange- 
ment of  the  accounts  on  the  Balance  Sheet  so  that  it  will  afford 
as  much  information  as  possible. 

"Often  no  attempt  is  made  to  classify  the  assets  and  liabili- 
ties. They  are  arranged  in  no  definite  form  or  order,  and  their 
nature,  other  than  by  their  name,  is  not  indicated.  It  seems 
their  only  purpose  is  to  state  the  amount  of  the  items  and  the 
total  thereof.  This  is,  of  course,  essential,  but  since  other  im- 
portant information  can  be  given  so  easily,  it  seems  desirable 
that  some  attention  be  given  to  the  classification  and  arrange- 
ment of  the  accounts. 

Classification  of  Assets  and  Liabilities.  "The  most 
simple,  and  at  the  same  time  the  most  important,  classification 
of  assets  and  liabilities  is  into  the  two  classes:  fixed  and  current. 
There  are  further  divisions,  but  the  above  are  the  most  important 
and  are  sufficient  for  elementary  work  in  accounting. 

"The  two  simple  Balance  Sheets  given  on  page  44  illustrate 
the  points  previously  discussed.  The  first  illustration  shows 
a  Balance  Sheet  in  the  form  frequently  used.  The  second  illus- 
tration shows  the  same  Balance  Sheet  with  the  assets  and  liabili- 
ties classified  as  current  and  fixed. 

"The  headings  of  Balance  Sheets  are  frequently  omitted 
or  stated  incorrectly.  The  form  shown  here  is  the  one  employed 
by  accountants  in  making  Balance  Sheets  to  submit  with  their 
reports.  Only  a  few  of  the  more  elementary  principles  in  regard 
to  the  Balance  Sheet  have  been  discussed  here." 


44 


PUBLIC  ACCOUNTING  AND  AUDITING 


JOHN  JONES 

Balance  Sheet  June  30,  1919 
Assets  Liabilities 


Cash 

Notes^Receivable 
Accounts  Receivable 
Merchandise  Inventory 
Furniture  &  Fixtures 
Real  Estate 


$  900 
2000 
2800 
6000 
400 
3000 

$15100 


Mortgages  Payable 
Notes  Payable 
Accounts  Payable 
John  Jones,  Capital 


$  20OO 
3000 
26OO 
7500 


$15100 


(Unclassified  Balance  Sheet) 


JOHN  JONES 


Balance  Sheet  June  30,  1919 


Assets 

Current  Assets : 

Cash  $  900 

Accounts  Receivable    2800 
Mdse.  Inventory  6000 

Notes  Receivable          2000 


Total  Current  Assets 
Fixed  Assets: 


$11700 


Furniture  &  Fixtures  $  400 

Real  Estate: 

Land  $1000 

Buildings      2000       3000 

Total  Fixed  Assets  $3400 


Total^Assets  $15100 


Liabilities 

Current  Liabilities: 

Notes  Payable  $3000 

Accounts  Payable  2600 

Total  Cur.  Liabilities  $5600 

Fixed  Liabilities: 

Mortgages  Payable  2000 

Total  Liabilities  $  7600 

Capital  or  Proprietorship: 

Invest.  June  30,  1919  $7000 
Profits  for  the  Year          500 

Present  Investment  7500 

Total  Liabilities  &  Prop.  $15100 


(Classified  Balance  Sheet) 


THE  LAW  OF  CONTRACTS  45 

THE  LAW  OF  CONTRACTS  (Continued) 

Contracts  are  not  always  valid.  They  may  be  illegal,  void, 
voidable  or  unenforceable.  The  validity  of  a  contract  depends 
upon  the  law  of  the  state  in  which  it  is  executed.  In  case  of  a 
suit  to  enforce  a  contract,  the  laws  of  the  state  in  which  the  suit 
is  brought  govern  the  remedy.  If  a  contract  is  executed  in  one 
state  and  is  delivered  in  another  state,  the  laws  of  the  state 
in  which  it  is  delivered  govern  the  delivery. 

Illegal  Contracts  are  always  void  and  have  no  standing 
whatever  in  the  eyes  of  the  law.  Agreements  to  do  anything 
contrary  to  law  or  agreements  against  the  public  policy  are 
illegal  and  void. 

A  Voidable  Contract  is  one  in  which  one  of  the  parties 
may  legally  refuse  to  carry  out  the  agreement,  but  at  the 
same  time,  if  the  injured  party  desires,  the  other  party  can 
be  compelled  to  carry  out  the  agreement.  It  will  be  seen  that 
the  law  is  protecting  one  of  the  parties,  but  not  the  other.  An 
example  is  a  contract  made  with  a  minor,  an  alien,  an  insane 
person,  or  an  intoxicated  person. 

An  Unenforceable  Contract  will  not  be  enforced  by 
courts  if  either  party  objects  to  its  terms.  Suppose  A  agrees 
to  sell  B  his  house  and  lot  for  $5,000.00  and  B  agrees,  orally  to 
buy.  The  contract  is  unenforceable  because  contracts  to  sell 
real  estate  must  be  made  in  writing,  or  at  least  there  must  be  a 
memorandum  in  writing. 

Mistakes.  A  Mistake  of  Fact  exists  when  a  mistake  has 
been  made  as  to  whom  one  is  contracting  with,  concerning  the 
subject  matter,  or  concerning  the  nature  of  the  contract.  When 
a  mistake  of  fact  exists  the  contract  is  void  and  cannot  be  en- 
forced. 

A  Mistake  of  Law  exists  when  a  party  misunderstands  the 
legal  effect  of  his  word  or  acts.  "Ignorance  of  the  law  excuses 
no  one,"  therefore,  a  mistake  of  law  is  no  cause  for  escape  from 
a  contract. 

Fraud.  Fraud  is  the  wilful  misrepresentation  of  material 
facts  and  if  proven  the  contract  becomes  voidable. 

Misrepresentation  in  the  form  of  a  mere  expression  of  an 
opinion  does  not  constitute  fraud.  When  fraud  is  performed, 
the  contract  may  be  declared  void  at  the  option  of  the  defrauded 
party,  but  can  not  be  annulled  by  the  one  committing  the  fraud. 

Alteration  of  a  contract  wrongfully,  amounts  to  fraud  and 
makes  it  voidable.  This  must  not  be  misconstrued.  If  one 
were  to  be  given  a  check  properly  signed  and  made  out  with 
the  exception  that  the  date  was  omitted,  he  would  have  the 
right  of  filling  out  what  was  understood  to  be  the  correct  date. 
Likewise,  if  the  amount  was  omitted,  he  might  fill  in  an  amount 
himself,  and  if  he  could  show  that  it  was  the  correct  amount  the 
check  would  be  good.  Do  not  sign  contracts  of  any  kind  with 
any  part  of  the  terms  blank.  Be  sure  that  they  are  properly 
filled  in  in  detail. 


46  PUBLIC  ACCOUNTING  AND  AUDITING 

A.     THEORY  QUESTIONS 

1.  What  is  the  chief  consideration  in  the  arrangement  of 
ledger  accounts?  C.  P.  A.  Ind. 

2.  What  is  meant  by  Controlling  Accounts?     Give  three 
illustrations  of  the  use  of  such  accounts.     State  the  advantages 
of  such  accounts.  C.  P.  A.  Ohio. 

3.  Describe  a  method  of  keeping  accounts  so  that  the 
aggregate  sums  due  from  customers  and  due  to  creditors  can 
be  known  without  preparing  a  schedule  of  the  accounts  of  such 
customers  and  creditors,  and  so  that  an  independent  balance 
of  the  ledger,  containing  only  the  real,  nominal,  special  and  con- 
trolling accounts,  exclusive  of  the  individual  accounts  of  cus- 
tomers and  creditors  may  be  taken.  C.  P.  A.  N.  Y. 

4.  Wherein  does  the  Trial  Balance  differ  from  the  Balance 
Sheet? 

5.  Would  you,  or  would  you  not,  be  satisfied  with  a  list 
run  off  on  an  adding  machine  by  some  one  connected  with  the 
institution    under   examination   after   you    had   compared    the 
amount  of  each  item  with  the  listed  figures?     Give  your  reason. 

C.  P.  A.  Del. 

B.     ACCOUNTING  PROBLEMS 

I.     For  the  six  months  ending  June  30,  1916,  the  balances 
appearing  on  the  books  of  George  Parker  are  as  follows: 

Cash  in  bank $    4,765.14 

Cash  on  hand 100.64 

Capital,  George  Parker 17,821.04 

Bills  Receivable 6,164.92 

Bills  Payable i  ,301 .90 

Debtors 20,903.88 

Creditors 6,263.12 

Purchases 255,642.42 

Sales 266,723.40 

Furniture  and  Fixtures 811.32 

Drawing,  George  Parker 4,000.00 

Discounts  Received 8,824.22 

Discounts  Allowed 5,240.52 

Expenses  New  York  office 3,762.18 

Expenses  branch  office 441.10 

Expenses  general  office 553-52 

Reserve  for  Bad  Debts 1,451.96 

Prepare  Trial  Balance  and  Balance  Sheet.    (No  merchandise 
inventory) . 


ACCOUNTING  PROBLEMS  47 

2.     A  manufacturer  is  desirous  of  securing  a  partner  and 
furnishes  a  statement  covering  five  years'  operations  as  follows: 

ASSETS. 

Buildings.  .  . $  20,000.00 

Machinery  and  Fixtures 75,000.00 

Inventory,  Mdse.  and  Supplies 50,000.00 

Cash 5,000.00 

Accounts  Receivable 40,000.00 

LIABILITIES. 

Accounts  and  Bills  Payable $  30,000.00 


Sales  average  per  year $500,000.00 

Wages  paid  per  year 1 70,000.00 

Expense,  Selling  and  General,  per  year.  .  .  .     35,000.00 
Material  purchased 260,000.00 

Buildings  are  on  leased  ground,  lease  expires  in  ten  years, 
annual  land  rental,  $1,000.00.  Buildings  revert  to  owner  at  ex- 
piration of  lease. 

New  machinery  when  installed  ten  years  ago  cost  $50,000.00. 
Additions  since  cost  $25,000.00.  No  depreciation  has  been 
charged  off.  All  repairs  and  replacements  charged  to  expense. 

What  in  your  opinion  would  be  a  fair  price  to  be  contrib- 
uted, for  a  half  interest?  Explain  fully.  C.  P.  A.,  Mich. 

(Note.  In  connection  with  this  problem  you  may  assume  that  upon 
investigation  you  ascertained  the  following  facts: 

(a)  That  the  accounts  receivable  are  guaranteed  to    be    collectible, 
hence  no  reserve  on  account  of  doubtful  accounts  need  be  made. 

(b)  That  the  inventory  of  merchandise  and  supplies  was  priced  at 
cost  and  that  the  accuracy  of  the  items  listed  was  tested  and  found  to  be 
accurate. 

(c)  That  the  buildings  are  so  constructed  that  at  the  expiration  of  the 
lease  they  will  have  no  residual  or  scrap  value,  hence  a  reserve  for  depreciation 
°f  5%  per  annum  for  the  past  ten  years  should  be  calculated  and  a  further 
reserve  of  5%  per  annum  should  be  set  up  during  the  remainder  of  the  lease. 

(d)  That  at  least  5%  depreciation  per  annum  for  ten  years  should  be 
calculated  on  machinery  costing  $50,000.00,  and  the  same  rate  per  annum 
for  a  period  of  five  years  on  new  machinery  costing  $25,000.00.    It  is  estimated 
that  the  machinery  will  continue  to  depreciate  at  a  rate  of  5%  per  annum. 

(e)  That  all  the  liabilities  are  stated  and  that  there  are  no  contingent 
liabilities. 

(f)  No  valuation  need  be  placed  on  good  will. 

Submit  a  statement  showing  how  you  arrived  at  the  value  of  a  half 
interest). 


48  PUBLIC  ACCOUNTING  AND  AUDITING 

C.  LEGAL  QUESTIONS 

1.  Distinguish  between  a  Mistake  of  Fact  and  a  Mistake 
of  Law. 

2.  What  makes  a  contract  illegal?  C.  P.  A.  Mich. 

3.  What  is  the  difference  between  fraud  and  misrepresenta- 
tion? C.  P.  A.  Ohio. 

4.  Define  or  describe,   void,  voidable  and  unenforceable 
contracts.  Inst.  Ex.  1917. 

5.  A  contract  executed  and  delivered  in  California  is  the 
subject  matter  of  a  suit  in  New  York.    What  laws  will  govern 
the  validity  of  the  contract,  and  what  laws  will  govern  the 
remedy?    State  the  rule  in  such  cases.  Inst.  Ex.  1917. 


Chapter  Four 

(NOTE. — As  a  student  of  accounting,  you  will  want  to  become  familiar 
with  the  practical  side  of  public  accounting  and  auditing,  and  in  order  that 
you  may  best  do  this,  the  actual  procedure  of  a  Balance  Sheet  audit  will  be 
discussed  in  the  following  chapters.  It  will  be  taken  up  in  such  a  manner  that 
you  will  have  an  opportunity  to  observe  the  work  of  both  junior  and  senior 
accountants). 

The  correspondence  shows  that  the  name  of  the  client  is  The 
Blank  Manufacturing  Company.  (See  Engagement  Blank, 
page  1 8,  for  details.)  A  firm  of  accountants  has  been  employed 
by  the  Board  of  Directors  to  make  a  Balance  Sheet 
audit  as  at  the  close  of  business  December  31,  1918,  principally 
for  credit  purposes,  but  also  to  establish  whether  there  have 
been  any  errors  of  principle  on  the  part  of  the  chief  accountant 
of  the  Company,  who  planned  the  system  of  accounts  in  use, 
and  who  heretofore  has  prepared  all  financial  statements.  Each 
accountant  has  been  furnished  with  a  letter  of  introduction  and 
the  usual  auditor's  equipment.  The  senior  in  charge  is  an  ex- 
perienced man  who  understands  how  to  direct  the  work  of  a 
number  of  juniors  and  has  full  authority  for  deciding  all  ques- 
tions relative  to  procedure  and  accounting  principles.  Two 
juniors  are  assigned  to  work  with  the  senior.  The  juniors  un- 
derstand that  when  they  are  in  doubt  relative  to  any  part  of 
the  work,  or  if  they  discover  anything  that  is  not  clear  to  them, 
they  are  to  report  immediately  to  the  senior  for  instructions. 
A  full  set  of  working  papers  must  be  kept  by  each  accountant 
relative  to  the  work  completed  by  him.  When  the  audit  is  com- 
pleted the  senior  will  arrange  all  working  papers  in  order  and 
make  a  report  to  the  managing  senior,  who  will  prepare  there- 
from final  reports  which  will  be  submitted  to  the  client. 

On  reporting  at  the  general  office  of  The  Blank  Manufac- 
turing Company  on  January  15,  1919,  and  being  properly  intro- 
duced to  Mr.  L.  W.  Shields,  general  manager,  Mr.  Harold  Pond, 
chief  accountant,  and  the  heads  of  departments,  the  senior 
is  given  a  Trial  Balance  taken  from  the  general  ledger,  and 
other  information  as  follows: 


49 


5o  PUBLIC  ACCOUNTING  AND  AUDITING 

Trial  Balance,  Dec.  31,  1918. 

Cash $  20, 162.00 

Cash  deposited  for  dividend  No.  9. ...      2,050.00 

Cash  deposited  for  bond  interest 2,500.00 

Land 100,000.00 

Buildings 150,000.00 

Machinery 100,000.00 

Tools  and  implements 20,215.00 

Horses,  wagons  and  harness 15,000.00 

Office  furniture 2,600.50 

Notes  receivable 12,906.00 

Accounts  receivable 81,687.00 

Sinking  fund 15,000.00 

Investment  of  surplus 10,000.00 

Salary  advances  to  salesmen 980.00 

Unapportioned  organization  expense. .       7,350.00 

Bond  discount  unamortized 6,000.00 

Div.  No.  9,  5%  authorized  7-1-18..    22,500.00 

Good  will 75,000.00 

Unsubscribed  stock 50,000.00 

Notes  payable $      21 ,000.00 

First  mortgage  5%,  2O-yr.  bonds.  .  . .  100,000.00 

Accounts  payable 51,780.50 

Due  to  officers  and  clerks 7,681.50 

Bond  interest  coupons  due 2,500.00 

Div.  No.  9,  vouchers  outstanding.  .  .  .  2,050.00 

Res.  for  baddebts,  less  $970  written  off  56.00 

Res.  for  depr.  on  buildings,  2^4%..  2,500.00 

Res.    for  depr.   on  machinery,  6%..  9,000.00 

Res.  for  dep.  on  horses  and  wagons, 10%  1 ,500.00 

Capital  stock,  5,000  shares  at $100 500,000.00 

Sinking  fund  reserve 15,000.00 

Sales  less  returns  and  allowances 625,275.00 

Rent  of  part  of  business  premises 250.00 

Inventory  12-31-17,  raw  material. . . .    37,310.50 
Inventory  12-31-17,  finished  stock. .  . .     15,000.00 

Purchases 195,000.00 

Factory  pay  roll,  labor 300,200.00 

In-freight  and  cartage 2,831.00 

Office  salaries  and  clerical  force 37,560.00 

Salaries  of  salesmen 30,220.00 

Advertising 25,150.00 

Taxes  paid 2,010.00 

Insurance 1,300.00 

Bond  interest 5,000.00 

Interest  and  discount 3,250.00 

Stable  expense 2,000.00 

Office  and  other  expense 12,875.00 

Maintenance  and  repairs 13,471.00 

Surplus,  12-31-17 _._. 38,535-00 

$1.377.128.00   $1.377.128.00 


CASH  51 

Inventory,  Dec.  31,  1918: 

Finished  stock $80,000.00 

Materials  and  stock  in  process 55,000.00 

Factory  pay  roll  accrued  but  not  paid 2,875.00 

Unexpired  insurance 456.00 

Interest  accrued  on  invested  surplus 126.32 

Interest  accrued  on  sinking  fund 875.34 

The  senior  ascertained  from  the  general  manager  and  the 
chief  Accountant  the  following  additional  information : 

1.  It  is  desired  to  set  aside  the  same  reserve  for  deprecia- 
tion as  at  the  end  of  the  previous  year. 

2.  The  practice  of  the  Company  has  been  to  charge  off 
10%  of  the  balance  of  organization  expense  annually  and  they 
prefer  to  continue  this  policy. 

3.  The  account  with  bond  discounts  is  being  charged  off 
at  the  rate  of  5%  annually. 

4.  It  is  estimated  that  2%  of  notes  and  accounts  receivable 
will  prove  to  be  worthless. 

5.  An  appropriation  of  $15,000  is  to  be  made  to  the  sinking 
fund  and  the  cash  from  same  to  be  placed  in  the  hands  of  a 
trustee  at  the  completion  of  this  audit. 

6.  The  balance  of  profits  available  for  distribution  is  to  be 
shown  as  a  credit  to  undivided  profits  or  surplus. 

The  chief  accountant  furnishes  the  senior  upon  request  with 
a  list  of  the  books  of  account  as  follows: 

Books  of  Original  Entry: 

(a)  General  journal.  (e)  Sales  returns  book. 

(b)  Purchases  book.  (f)   Cash  receipts  book. 

(c)  Purchases  returns  b*bok.     (g)  Cash  payments  book. 

(d)  Sales  book.  (h)  Notes  receivable  book. 

(i)   Notes  payable  book. 

Ledgers.  In  addition  to  the  general  ledger,  there  is  kept 
subsidiary  ledgers  with  customers  and  with  creditors. 

CASH 

The  senior  having  prepared  an  audit  program,  directs  one 
of  the  juniors  to  proceed  with  the  count  of  cash  and  the  verify- 
ing of  the  cash  and  bank  balances. 

1.    ACCOUNTING  THEORY 

The  Theory  of  the  Cash  Account.  This  account  is 
usually  kept  with  more  care  than  any  other  account,  though 
it  is  difficult  to  understand  why  a  business  man  should  safe- 
guard his  cash  with  any  greater  degree  of  care  than  other  assets 
representing  money's  worth  or  cash  value.  If  as  great  pre- 
caution were  used  in  the  keeping  of  accounts  with  merchandise 
as  is  used  with  cash,  there  would  be  much  less  temptation  for 


52  PUBLIC  ACCOUNTING  AND  AUDITING 

fraud,  theft,  etc.  The  average  business  man  is  satisfied  to  take 
a  physical  inventory  of  merchandise  once  a  year,  but  counts  his 
cash  daily. 

Accountants  advocate  the  keeping  of  an  account  with  cash 
in  the  general  ledger.  It  partakes  of  the  nature  of  a  controlling 
account  since  it  is  debited  only  with  the  total  receipts  and  cred- 
ited only  with  the  total  payments  at  the  end  of  each  designated 
period,  usually  at  the  end  of  each  month.  Many  bookkeepers 
keep  only  a  cash  book  and  do  not  keep  an  account  with  cash  in 
the  general  ledger.  The  bookkeeper  simply  refers  to  the  cash 
book  for  the  cash  balance  when  preparing  the  Trial  Balance. 
The  general  ledger  is  supposed  to  balance,  independent  of  all 
the  other  books  of  account,  but  will  not  do  so  unless  an  account 
is  kept  with  cash. 

Several  forms  of  cash  books  will  be  found  in  use.  They 
have  been  devised  for  all  sorts  of  reasons  and  to  meet  all  kinds 
of  conditions.  They  run  the  scale  from  a  cash  book  with  only 
a  general  column  on  each  side  to  a  complicated  form  of  cash 
journal  containing  all  the  transactions,  either  individually  or 
in  summary.  Then,  too,  the  cash  book  will  be  found  divided, 
one  being  kept  for  receipts  only  and  another  for  payments. 
This  division  enables  two  bookkeepers  to  work  on  the  cash 
books  at  the  same  time,  one  handling  receipts  and  another 
handling  disbursements.  This  is  an  advantage  in  large  concerns, 
and  there  is  also  less  chance  for  embezzlement.  In  some  cases  a 
separate  cash  book  is  kept  for  recording  receipts  from  trade  cus- 
tomers only,  or  one  for  recording  payments  to  trade  creditors  only. 

Imprest  System.  Since  it  is  important  that  all  receipts 
be  deposited  in  the  bank  and  all  payments  be  made  by  check, 
there  has  come  into  use  what  is  known  as  the  PETTY  CASH 
FUND  or  IMPREST  SYSTEM. 

A  certain  sum  is  drawn  from  the  bank  by  writing  a  check 
payable  to  Petty  Cash,  the  proceeds  of  which  is  placed  in  the 
care  of  a  petty  cashier  whose  duty  it  is  to  pay  out  small  sums 
below  a  certain  amount.  An  account  is  kept  with  Petty  Cash 
and  at  certain  periods  the  cashier  presents  a  record  of  his  dis- 
bursements supported  by  vouchers  and  the  fund  is  replenished. 
There  are  slightly  different  methods  in  handling  the  Petty  Cash 
and  the  different  methods  should  be  thoroughly  understood. 

J.  W.  Baker,*  in  discussing  the  Petty  Cash  Fund,  writes: 

"All  cash  received  should  be  deposited,  and  all 
payments  made  by  check.  If  it  is  necessary  to  make 
small  payments,  these  should  be  made  from  a  fund 
kept  on  hand  for  this  purpose.  This  fund  is  known  as 
the  'Petty  Cash  Fund'  or  'Imprest  Fund'.  It  is  created 
by  withdrawing  from  the  bank  an  amount  sufficient  to 
meet  these  payments.  This  may  be  $10.00,  $20.00, 

*2Oth  Century  Bookkeeping  and  Accounting. 


CASH  53 

).oo,  or  $100.00,  according  to  the  amounts  required. 
The  check  needed  to  establish  the  fund  is  entered  in  the 
general  cash  book,  the  same  as  other  checks,  the  amount 
being  debited  to  a  Petty  Cash  Fund  or  Imprest  Fund 
account  in  the  general  ledger.  When  the  fund  has  been 
exhausted  by  the  payments,  another  check  is  drawn  for 
the  amount  necessary  to  replenish  the  fund.  At  this 
time  the  proper  accounts  are  charged  in  the  general 
cash  book  for  the  payments  from  the  petty  cash  fund. 
The  amount  (balance  of  the  Petty  Cash  Fund  account) 
remains  the  same  until  the  account  is  closed,  which 
would  be  at  the  end  of  the  fiscal  period,  or  when  the 
imprest  system  is  discontinued." 


Fraud.  The  professional  auditor  learns  from  experience 
that  there  are  certain  methods  whereby  a  bookkeeper  may 
dishonestly  abstract  funds  of  a  company  and  still  keep  his  books 
and  accounts  in  balance.  The  following  are  a  few  of  the  more 
common  methods  which  an  auditor  should  always  be  able  to 
detect  during  the  course  of  a  professional  audit: 

1 .  The  bookkeeper  may  withhold  a  part  of  the  cash  receipts 
and  make  no  entry  whatever  on  the  books  of  account,  neither 
recording  the  receipt  of  cash  nor  the  credit  to  the  customer's 
account. 

4Q 

2.  The  bookkeeper  may  withhold  a  part  of  the  cash  re- 
ceived and  instead  of  recording  it  as  a  cash  receipt  may  credit 
the  customer  for  an  allowance  on  returned  goods. 

3.  After  the  cash  has  been  entered  in  the  cash  book  and 
properly  posted  to  the  correct  account,  the  bookkeeper  may 
alter  the  cash  book  footings  so  that  they  will  show  a  smaller 
amount  of  receipts  or  a  larger  amount  of  payments  and  then 
withhold  cash  equal  to  the  amount  of  the  difference. 

4.  The  bookkeeper  may  withhold  a  part  of  the  cash  re- 
ceipts making  no  entry  in  the  cash  book,  but  may  enter  directly 
in  the  ledger  a  credit  to  the  customer's  account,  and,  at  the 
same  time,  make  a  fictitious  debit  to  some  other  customer's 
account  in  order  to  keep  the  ledger  in  balance. 

5.  The     bookkeeper     may     pay    cash     to    offset    some 
invoice    previously    entered   fraudulently,    the    invoice    having 
been  charged  to  some  expense  account.     Of  course,  the  book- 
keeper would  abstract  the  cash  thus  paid  and  make  the  proper 
entry  on  the  credit  side  of  the  cash  book. 

6.  A  sale  to  a  customer  on  account  may  not  be  recorded 
at  all  and  when   the  cash  is  received  the  bookkeeper  simply 
withholds  it,  making  no  entry  therefor. 


54  PUBLIC  ACCOUNTING  AND  AUDITING 

7.  A  process  of  "overlapping"  may  be  resorted  to.  In 
this  way  the  bookkeeper  may  withhold  cash  as  received  and 
substitute  therefor  subsequent  receipts  of  cash  as  they  come 
in.  This  is  kept  up  continuously  so  as  to  cover  the  original 
discrepancies. 


Suggestions   to   Eliminate   Possibility  of  Fraud.     If 

the  system  for  handling  the  cash  and  cash  items,  and  for  keep- 
ing the  accounts  and  records  in  connection  with  cash  is  properly 
planned,  possibility  of  fraud  may  be  largely  eliminated.  The 
policy  of  internal  check  should  be  carefully  followed.  The 
following  general  suggestions  will  aid  materially  in  planning 
the  system  of  accounts  and  the  system  of  internal  check  so  as 
to  prevent  fraud  in  connection  with  the  handling  of  cash: 

1 .  Do  not  permit  the  bookkeeper  who  keeps  the  personal 
accounts  to  act  as  cashier.     The  one  who  records  the  receipts 
and  payments  of  cash  in  the  cash  book  should  not  have  access 
to  the  customers'  and  creditors'  ledgers. 

2.  The  entire  cash  receipts  must  be  deposited  in  the  bank 
regularly — daily  if  convenient.    When  this  plan  is  carried  out, 
the  cash  receipts  will  be  exactly  equal  to  the  deposits  in  the 
bank  during  any  month  or  during  the  entire  fiscal  period. 

3.  All  disbursements  must  be  made  by  check.     This  does 
not  mean  that  petty  disbursements  cannot  be  made  in  cash. 
The  petty  cash  fund  can  be  created  and  replenished  from  time 
to  time  by  check  and  the  petty  cashier  should  be  required  to 
account  for  all  disbursements  of  whatever  nature  by  properly 
signed  vouchers. 

4.  The  check  book  should  be  in  the  custody  of  the  one 
who  signs  the  checks.     This  will  usually  be  the  cashier.     The 
bookkeeper  should  not  have  access  to  the  check  book. 

The  suggestions  above  will  not  in  themselves  prevent  the 
fraudulent  withholding  of  cash  and  failure  to  properly  record 
receipts,  neither  will  they  prevent  "overlapping."  This  can 
be  overcome  to  a  certain  extent  by  arrangements  whereby  the 
cash  receipts  are  handled  by  more  than  one  person.  For  instance, 
a  list  of  the  cash  receipts  may  be  made  at  the  time  the  mail 
is  opened.  The  cash  and  cash  items  are  then  given  to  the  cashier 
for  recording  and  for  deposit.  In  this  way,  two  different  persons 
are  charged  with  the  handling  of  the  cash  receipts.  The  book- 
keeper may  post  to  the  customers'  accounts  direct  from  the 
list,  or  from  the  cash  book.  At  any  rate,  the  list  of  cash  receipts 
should  go  to  an  officer  of  the  company  who  can  later  compare' 


CASH  55 

the  total  receipts  with  the  total  deposits.  If  customers  are 
billed  regularly,  any  who  have  not  been  given  credit  for  the  full 
amount  of  their  payment  would  be  certain  to  enter  a  complaint. 
It  will  be  seen  that  the  object  of  any  arrangement  similar  to 
this  is  to  inaugurate  an  internal  check.  So  much  depends  upon 
the  volume  of  business  that  it  is  difficult  to  outline  a  set  of 
rules;  in  fact,  it  would  not  be  good  policy  to  attempt  to  do  so, 
because  a  system  that  would  constitute  a  good  internal  check 
in  one  business,  would  not  necessarily  prove  satisfactory  in 
another. 

2.     AUDITING  THEORY 

Counting  the  Cash.  This  should  be  done  at  the  close  of 
business  and  on  the  last  day  of  the  period  under  audit  if  possible. 
However,  it  more  frequently  happens  that  the  audit  takes  place 
subsequent  to  the  close  of  the  accounting  period,  therefore,  it 
is  best  to  count  the  cash  on  the  first  day  of  the  audit  at  the  close 
of  business. 

Some  advocate  that  it  is  best  to  permit  the  person  who  is 
in  charge  of  the  cash  to  handle  it  and  do  the  actual  counting  for 
the  reason  that  he  is,  as  a  rule,  skilled  in  the  handling  of  cash. 
Another  reason  for  it  is  that  if  the  auditor  does  not  handle  the 
cash  in  person,  he  avoids  the  possibility  of  becoming  involved 
in  any  irregularities.  In  case  the  cashier  or  person  in  charge  of 
cash  is  permitted  to  count  it,  the  auditor  must,  of  course,  super- 
vise the  count  with  the  greatest  care. 

In  counting  the  cash,  the  auditor  must  ascertain  that  all 
customer'  checks,  produced  as  a  part  of  the  cash  balance,  have 
been  properly  entered  in  the  cash  book  prior  to  the  close  of  busi- 
ness on  that  date,  and  should  note  the  dates  and  descriptions 
of  such  checks  as  well  as  the  dates  and  descriptions  of  such 
advances  made  of  cash  and  not  recorded  on  the  books.  Any 
advances  to  employees  should  be  carefully  investigated,  and  if 
they  are  secured  by  personal  che.cks  the  auditor  should  see  that 
the  checks  are  certified  by  the  bank  on  which  they  are  drawn 
before  the  close  of  the  audit. 

Any  unusual  cash  items,  such  as  I.  O.  U.'s,  should  be  care- 
fully listed  for  investigation.  However,  the  auditor  should 
not  adopt  an  attitude  with  regard  to  such  matters  that  will 
react  against  him.  If  an  employee  owes  an  item  of  a  few  cents 
because  he  could  not  make  change,  it  is  not  necessary  to  take 
the  matter  up  with  the  head  of  the  department  or  the  president 
of  the  company.  It  is  expected  that  anyone  competent  to  act 
as  either  a  junior  or  senior  auditor  will  be  able  to  use  the  proper 
discretion  in  such  matters.  One  will  frequently  find  bad  coins 
that  have  been  taken  in  unknowingly.  These,  of  course,  must 
be  taken  into  consideration,  but  it  does  not  justify  criticism  or 
fault-finding.  Do  not  adopt  the  attitude  of  a  detective. 


56  PUBLIC  ACCOUNTING  AND  AUDITING 

Verifying  the  Bank  Balance.  Certificates  must  be  obtained 
from  the  various  banks  in  which  accounts  are  maintained,  as  at 
the  close  of  business,  on  the  same  day  that  the  cash  balance  is 
counted,  preferably  on  the  last  day  of  the  fiscal  period.  If  this 
is  not  possible,  then  on  the  first  day  of  the  audit.  This  is  done 
by  presenting  to  the  banks  a  request  signed  by  the  depositor 
or  his  agent  asking  for  a  certificate  showing  the  balance  on  a 
certain  date.  This  certificate  should  be  mailed  to  the  auditor, 
not  to  the  depositor. 

Reconciling  the  Bank  Certificate.  This  is  done  by  check- 
ing the  deposits  with  the  cash  book  and  vouching  the  payments 
with  the  cancelled  checks.  The  bank  balance  will  naturally 
vary  from  the  cash  book  balance  on  account  of  checks  outstand- 
ing. The  outstanding  checks  should  be  listed  for  future  refer- 
ence. Where  several  banks  are  used  as  depositories,  this  be- 
comes more  complicated,  but  the  general  plan  of  procedure  is  the 
same.  Having  made  a  list  of  the  checks  outstanding,  these  may 
be  investigated  before  the  audit  is  completed,  when  it  will 
likely  be  found  that  most  of  them  have  been  presented  to  the 
bank  for  payment.  Any  still  outstanding  should  be  especially 
investigated. 

"Kiting"  Checks.  It  is  well  to  be  familiar  with  the  process 
commonly  known  as  the  "kiting  of  checks".  This  can  be  detect- 
ed by  checking  in  detail  the  deposits  of  the  last  few  days  of  the 
fiscal  period  and  comparing  with  the  receipts  in  the  cash  book. 
If  a  check  drawn  on  one  bank  by  the  Company  was  deposited 
in  another  bank  without  being  credited  to  the  bank  on  which  it 
was  drawn  prior  to  the  close  of  the  fiscal  period,  a  false  balance 
would  be  established.  Be  sure  that  a  check  drawn  on  one 
bank  and  deposited  in  another  bank  is  properly  entered. 

Since  it  is  considered  the  better  practice  to  deposit  all  receipts 
in  the  bank,  it  is  well  to  obtain  some  of  the  old  deposit  tickets  and 
compare  them  with  the  cash  receipts  in  the  cash  book  to  deter- 
mine whether  or  not  the  cash  receipts  were  properly  deposited. 
This  can  also  be  determined  by  comparing  the  total  deposits  for 
any  certain  period  with  the  total  cash  receipts  of  the  same  period. 

Working  Back  the  Cash.  Usually  an  audit  is  made  some 
days  after  the  close  of  the  period.  This  necessitates  the  count 
ing  of  cash  on  a  later  date  and  working  back  to  the  day  desired. 
After  the  exact  cash  balance  has  been  determined  on  the  date 
of  audit,  add  the  disbursements  and  deduct  the  receipts  and  the 
balance  for  the  date  desired  will  be  obtained.  This  should  be 
compared  with  the  cash  book  balance  on  the  date  of  the  close 
of  the  fiscal  period. 

To  illustrate  this  procedure: 

March  10,  1919,  balance  per  cash  book. $12, 380. 24 
Add  disbursements,  since  Dec.  31,  1918.     6,205.18 

$18,585.42 

Deduct  receipts  since  Dec.  31,  1918.  .  .  .     4,756.98 
Balance,  Dec.  31,  1918,  end  of  period..  .$13,828.44 


CASH  57 

3.     AUDITING  PROCEDURE 

The  junior  assigned  to  count  the  cash  and  verify  the  bank 
balance,  proceeded  by  first  making  a  count  of  the  cash  on  hand. 
His  working  papers  show  (see  illustration  on  page  58)  the  result 
of  his  count.  Among  the  checks,  there  was  one  signed  by  C.  P. 
Cooley,  which  has  been  returned  from  the  bank,  marked  "No 
funds".  Investigation  showed  that  shortly  before  the  auditor 
began  counting  the  cash  the  bank  had  returned  the  check,  the 
cashier  having  settled  by  writing  a  new  check  payable  to  the 
bank  for  the  proper  amount,  $17.76.  This  check,  however,  had 
not  been  entered  in  the  cash  book.  After  talking  it  over  with  the 
cashier,  the  proper  entry  was  made,  charging  the  amount  back 
to  the  customer's  account,  and  the  check  was  not  included  in 
the  cash  balance. 

Verification  of  the  cash  receipts  book  and  cash  payments 
book  footings  showed  for  the  first  fifteen  days  of  January: 

Receipts $36,994.89 

Payments 31,402.08 

Excess  receipts 5,592.8i 

According  to  the  Trial  Balance,  the  cash  balance  on  Dec.  31, 
1918,  was  $20,162.00.  Adding  to  this  the  excess  receipts  for  the 
first  fifteen  days  of  January,  1919,  it  will  be  seen  that  the 
cash  balance  at  this  date  should  be  $25,754.81.  The  count  of 
cash  on  hand  shows  a  balance  of  $4,971.70.  Therefore,  there 
should  be  a  balance  in  the  bank  at  this  time  of  $20,783.11  after 
deducting  the  sum  of  all  outstanding  checks. 

Bank  Certificate.  The  senior  mailed  a  letter  to  the  bank 
requesting  a  certificate  showing  the  balance  to  the  credit  of  the 
Blank  Manufacturing  Co.,  at  the  close  of  business  on  January 
J5»  I9I9-  It  is  customary  with  banks  to  furnish  this  informa- 
tion, but  it  is  first  necessary  to  have  your  request  approved  by 
the  client.  Banks  do  not  like  to  give  out  information  without 
the  permission  of  the  depositor. 

The  bank  responded  with  a  certificate  showing  a  balance 
on  January  15,  1919,  to  be  $28,950.50,  divided  into  three  funds, 

General  checking  account $24,400.50 

Fund  for  Dividend  No.  9 2,050.00 

Fund  for  Bond  interest 2,500.00 

The  bank  also  returned  to  the  Blank  Manufacturing  Co.  the 
canceled  checks. 

After  obtaining  the  bank  certificate  and  the  canceled  checks 
the  junior  continued  his  work  by  reconciling  the  bank  balance. 
(See  illustration  on  page  59.) 

He  found  that  the  following  checks  had  been  issued  but  had 
not  as  yet  passed  through  the  bank: 


58  PUBLIC  ACCOUNTING  AND  AUDITING 

No.  Date.                          Payee  Amount. 

4527  12/8/18  Flint  &  Walling  Mfg.  Co $    765.80 

4597  I/5A9  A.  S.  Morrow  &  Co.  1,499.10 

4599  I/7/I9  Geo.  A.  Barns  75.00 

4670  1/10/19  L.  W.  Kindow  985.00 

4682  i  /I4/I9  Robert  E.  Arnes  &  Son  292.49 


;,6i7-39 


Cash                  THB  BLAK  UAKD7ACTUBIKQ  CO.             0.  B.  Sha*, 
oount:               "                                   Junior 

Jan.  15,  1919—5:30  P.  11. 

B.  S.  Dates,  Caehier. 

25 

30 

40 
10 
80 

JO 
4 
4 

6 

36 
33 
23 
14 
41 

Bills: 
480 
10 
6 
2 
1 

lol&t 
too 

10 
6 

Silver: 

1  1 
.50 
.25 
.10 
.05 
.01 
Total  cash  on  hand 

Cash  items: 
Checks 
Jan.  11          C.  P.  Mo  Garry 
13          P.  B.  Admire 
14          A.  S.  Handeok 
10          8.  W.  Gerring 
6         S.  H.  Lehman 
15         H.  S.  Biddlnger 
9          S.  J.  Husiofc 
8          W.  A.  Wirtz 
14          C.  W.  Jones 
12          C.  C.  White 

Miscellaneous 
P.  0.  Money  Order    W.  W.  Ward 
Express  Money  Order  ,  J.  S.  Joiner 

Total  cash 

*500 
800 
200 
20 

,   80 

CO 
00 
00 
00 
00 

$1100 

00 
.00 

16 

$1396 
3576 

16 

54 

•200 
40 
20 

00 
00 
00 

260 
26 

6 
17 
8 
2 

00 

50 
25 
30 
70 
41 

75 
154 
£2 
87 
1 
1M 
156 
821 
1880 
_1347 

29 
00 
93 
60 
50 
90 
00 
80 
10 
86 

8571 
4 

98 

66 

1 
2 

60 

96 

4971 

70 

(Ai-Working  Sheet,  C.  E.  Shaw,  junior  accountant, 
tographed  and  reduced  one-half.) 


Pho- 


CASH 


59 


The  junior  ascertained  the  following  additional  facts: 

(a)  That  the  footings  of  the  cash  book  were  in  ink. 

(b)  That  it  was  the  custom  of  the  company  to  make  a  de- 
posit each  day -at  noon. 

(c)  That  the  cash  on  hand  represented  receipts  since  the 
last  deposit  was  made  at  noon,  Jan.  15,  1919. 

(d)  That  this  deposit  was  shown  in  the  bank  certificate. 

(e)  That  the  checks  listed  had  all  been  entered  in  the  cash 
receipts  book. 

(f)  That  the  check  written  in  favor  of  the  bank  on  Jan.  15, 
1919,  on  account  of  the  check  returned  by  the  bank  with  the 
notation,  "no  funds",  had  been  deducted  from  the  balance  as 
shown  on  the  certificate. 


THE  BLAHK  MAHtnTACTOHIUG  CO. 


(a)  Verification  of  cash  book  balance        C.  E.  Shaw, 
It]  Beoonoiliatlon  of  Bade  balanoa            Junior 

Completed  Jan.  16,  1919 

Balance  (Jan.  15,  1919)  as  per  bank 
certificate  attached  hereto 

Deduct 
Fund  for  Dividend  Ho.  9 
Fund  for  Bond  interest 
Balance  in  general  checking  account 

Deduct  cheeks  in  transit: 
No.  4527 
4697 
4699 
4670 
4662 
Available  balance  in  bank 

Add  oash  on  hand  (BOS  record  of 
count  attached) 
Cash  balance  Jan.  15,  1919 

WOBJCIHC  BACK: 
Add  disbursements  (Jan.  1  to  15) 

Deduct  receipts  (Jan.  1  to  16) 
Cash  balance  Dec.  SI,  1918  ' 

Total  cash  receipts  book,  Jan.  15,  1919 
Total  cash  payments  book,  Jan.  15,  1919 
Sxoess  receipts 
Add  C.  B.  balance  Doc.  21,  1913 
C.  B.  balance  Jan.  15,  1919 

k£0£0 

^600 

00 
09 

$£9950 
4550 

60 

00 

|2440P 

-jjni. 

20733 
4971 

60 

_£S 
11 

7Q 

765 
1499 

75 
986 
292 

80 
10 
00 
00 
•49 

36594 
S3.*02 

~BW 

£016$ 

89 

08 

TT 
09 

X  25764 
&UQ8 

ei 
Q«? 

6716ft 

.  36m 

o? 

li 

£016.8 

ft 

(-E5V54 

Cl 

(A2-Working  Sheet,  C.  E.  Shaw,  junior  accountant, 
tographed  and  reduced  one-half.) 


Pho- 


60  PUBLIC  ACCOUNTING  AND  AUDITING 

THE  LAW  OF  CONTRACTS  (Continued) 

Assignment  of  Contracts.  Contracts  which  do  not  de- 
pend on  personal  service,  skill,  ability,  or  trustworthiness  of  one 
or  all  of  the  parties  involved  may  be  assigned  by  either  of  the 
parties.  Of  course,  if  one  of  the  conditions  in  a  contract  forbid 
its  assignment,  it  could  not  be  assigned.  Assignments  should 
be  in  writing,  whether  the  contract  is  an  oral  or  a  written  one. 
If  it  is  a  written  one  the  assignment  can  be  made  on  the  back  of 
the  contract,  and  if  it  is  an  oral  one  the  assignment  can  be  made 
in  writing  anyway.  A  contract  governed  by  the  Statute  of 
Frauds  must  be  assigned  in  writing.  However,  there  is  nothing 
to  prevent  the  assignment  of  contracts  not  governed  by  the 
Statute  of  Frauds  by  "word  of  mouth"  or  by  "delivery". 

The  assignee  becomes  liable  to  perform  all  the  duties  of  the 
party  who  assigns  the  contract  and  receives  only  such  rights  as 
the  original  party  enjoyed.  His  title  is  no  better  than  that  pos- 
sessed by  the  original  party.  If  the  other  parties  possessed  any 
defenses  against  the  assignor,  they  possess  the  same  defenses 
against  the  assignee.  By  defenses  is  meant  fraud,  duress, 
undue  influence,  offset,  etc. 

Novation.  A  novation  is  the  substitution  of  other  parties, 
or  another  party,  not  originally  bound  by  the  contract,  for  one 
of  the  original  parties  to  the  contract.  This  can  be  accomplished 
only  by  agreement  of  all  the  parties  concerned. 

Discharge.  There  are  five  principal  means  of  discharging 
contracts: 

1.  By  performance. 

2.  By  agreement. 

3.  By  operation  of  law. 

4.  By  intervention  of  impossibility. 

5.  By  breach  of  contract. 

Performance.  This  is  the  simplest  method  of  discharging 
contracts  and  it  is  the  usual  way.  When  all  parties  to  a  con- 
tract have  fulfilled  their  agreement  in  full,  the  contract  is  dis- 
charged. 

Agreement.  By  mutual  agreement,  all  the  parties  to  a 
contract  may  set  it  aside,  thereby  discharging  it.  However, 
this  agreement  is  simply  another  contract  and  must  conform  to 
all  the  conditions  of  a  legal  contract.  Usually  there  is  simply 
an  oral  agreement  that  the  contract  be  discharged,  that  is,  a 
mutual  understanding  of  all  the  parties  concerned.  It  should 
be  definitely  understood,  and  in  some  cases,  it  would  be  best  to 
put  it  in  writing. 


THE  LAW  OF  CONTRACTS  61 

Operation  of  Law.  A  contract  may  be  discharged  by  the 
making  of  a  new  contract.  Usually  this  is  one  of  a  higher  order. 
A  written  agreement  discharges  an  oral  agreement  and  an  agree- 
ment under  seal  discharges  a  simple  contract  in  writing.  Prac- 
tically all  contracts  are  discharged  by  bankruptcy.  Taxes, 
judgments,  alimony  allowances,  and  debts  created  by  fraud, 
embezzlement,  misappropriation,  or  defalcation  while  in  charge 
of  a  trust  are  exceptions  to  the  rule  of  discharge  by  bankruptcy. 
Death  discharges  executory  contracts  for  personal  service  in 
which  skill  and  taste  are  involved. 

Intervention  of  Impossibility.  A  contract  to  do  some- 
thing that  was  impossible  from  the  beginning  is  void.  It  is  best, 
however,  to  make  provision  in  the  contract  for  strikes,  war, 
acts  of  God,  etc.  By  "acts  of  God"  is  meant  floods,  tornadoes, 
hurricanes,  public  calamities,  etc. 

Breach  of  Contract.  Violation  of  the  terms  of  a  contract 
is  called  a  breach  of  contract.  The  innocent  party  to  a  contract 
may  be  discharged  from  further  liability  if  the  other  party  fails 
to  do  something  which  he  agreed  to  do  or  does  something  which 
he  agreed  not  to  do.  If  the  breach  is  such  that  the  innocent 
party  is  not  discharged  from  his  obligations,  he  will  be  entitled 
to  either  money  damages  or  to  the  right  of  "specific  perform- 
ance". 

A  court  may  compel  a  party  to  a  contract  to  do  as  he  agreed 
to  do  or  to  perform  all  the  terms  of  the  contract.  This  is  known 
as  a  "specific  performance." 

A  Tender  is  an  offer  to  pay.  A  tender  of  payment  or  an 
offer  to  perform  the  conditions  of  a  contract  does  not  discharge 
the  contract.  One  may  avoid  penalty  for  non-payment,  court 
costs,  and  interest  on  the  debt  from  the  time  of  the  offer  by 
making  a  tender;  but  he  must  hold  himself  ready  to  pay  or 
perform  the  conditions.  In  case  the  offer  to  pay  is  made  in 
money,  it  must  be  made  in  legal  tender. 

Legal  Tender  is  that  currency  or  money  which  the  law 
authorizes  a  debtor  to  tender  and  requires  a  creditor  to  receive 
in  payment  of  money  obligations. 

All  gold  coins  of  the  United  States  are  a  legal  tender  in 
all  payments  at  their  nominal  value  when  not  below  the  stan- 
dard weight  and  limit  of  tolerance  provided  by  law  for  the  single 
piece,  and  when  reduced  in  weight  below  such  standard  of  tol- 
erance, they  are  a  legal  tender  at  valuation  in  proportion  to 
their  actual  weight. 

Treasury  notes  and  standard  silver  dollars  for  all  pay- 
ments. 

Silver  coins  of  a  smaller  denomination  than  one  dollar 
for  all  sums  not  exceeding  $10.00. 

Nickels  and  pennies  for  sums  not  exceeding  25c. 


62 


PUBLIC  ACCOUNTING  AND  AUDITING 


Notes  of  the  United  States  for  all  debts,  public  and  private, 
except  duties  on  imports  and  interest  on  the  public  debt. 

Gold  certificates  payable  to  bearer  were  made  legal  tender 
under  a  Senate  bill  passed  by  the  House  December  19,  1919, 
and  signed  by  the  President. 

The  following  chart  is  intended  as  a  general  review  of  con- 
tracts and  should  be  carefully  studied. 

I. — Competent  parties 
2. — Mutual  agreement 
3. — Sufficient  consideration 
4. — Legal  subject  matter 
5. — Compliance  with  Statute 
of  Frauds. 


Contracts^ 


I. — As  to  Essentials^ 


f  I  .  —  Under  seal  —  Parol 
2'—  £s1to    .     J  f  i.—  Written 

Solemnity  [  2>_Simple    2.—  Oral 

[  3.  —  Implied 

f  I.—  Valid 

3.—  As  to  Validity!  2'~^°!<j  .  . 
7  j  3.  —  Voidable 

[  4.  — 


4. — As  to  Effects 


Unenforceable 


fi.-Mistakes(°J  facts 

2.-Fraud      I  of  Law 
3. — Duress 
4. — Undue  influence 
5. — Alteration 


5. — As  to  Discharge- 


i. — By  performance 
2. — By  agreement 
3. — By  intervention  of  impos- 
sibility 

4. — By  operation  of  law 
5. — By  breach 


A.    THEORY  QUESTIONS 

1 .  If  in  the  examination  of  the  accounts  of  a  merchant,  the 
balance  shown  in  the  bank,  or  the  balance  as  certified  by   the 
banker,  agreed  with  the  balance  as  disclosed  on  the  merchants' 
cash  book,  would  you  consider  any  further  examination  neces- 
sary? C.  P.  A.  Ind. 

2.  The  cashier  of  a  firm  had  disappeared.    The  cash  book 
is  left  written  up  and  balanced  off,  the  custom  being  to  pay  any 
cash  balance  into  the  bank  each  day.    What  course  would  you 
pursue  to  ascertain  whether  there  were  any  defalcations. 

C.  P.  A.  Mich. 


ACCOUNTING  PROBLEMS  63 

3.  Name  some  of  the  advantages  of  the  use  of  additional 
columns  in  the  cash  book.  C.  P.  A.  Ohio. 

4.  If  the  actual  cash  on  hand  at  the  date  of  the  Balance 
Sheet  had  not  been  verified  by  the  auditor  on  the  day  of  balanc- 
ing, what  method  should  be  employed  to  prove  the  correctness 
before  signing  or  certifying  the  statements.  C.  P.  A.  N.  Y. 

5.  You  are  required  to  make  a  detailed  cash  audit  for  three 
years  ending  October  31,  1917.     You  find  a  disbursement  for 
"Rent  October,  1914,  $1,000.00"  on  November  6,  1914.     You 
are  told  the  receipt  is  missing  and  the  duplicate  cannot  be  ob- 
tained.   You  are  shown  as  a  voucher  a  check  dated  November 
6,  1914,  payable  to  the  landlord  or  order  for  $1,000.00,  endorsed 
with  a  rubber  stamp  and  marked  by  the  client's  bankers  "paid". 

State  with  your  reasons  whether  you  would  accept  this  as 
sufficient  evidence  that  the  payment  was  made  as  recorded  and, 
if  not,  what  course  you  would  adopt.  Inst.  Ex.  1917. 

B.    ACCOUNTING  PROBLEMS 

1.  The  result  of  your  count  of  the  "Cash  on  Hand"  at  a 
large  agency  on  January  I,  1912,  discloses: 

Bills $1,979.00 

Coins : 484.19 

Cash    items    supported    by    properly 
signed  vouchers : 

Jan.    14,  1908,  Sub-agent    Jones $200.00 

July    20,  1909  Thomas..   140.00 

Aug.   20,  1909,  Vincent. .     75.00 

Sept.  30,  1910,  Nelson...  230.00        645.00 

Cash  balance  as  per  general  ledger $3,108.19 

Does  this  count  complete  your  duty  as  an  auditor?  If  you 
consider  that  further  steps  are  necessary,  state  what  you  would 
do.  C.  P.  A.  La.  and  Ore. 

2.  The  cash  book  of  a  general  trading  concern  shows  for 
the  month  of  January,  1912,  the  following: 


1912 

RECEIPTS 

Jan.    4 

Collections  from 

customers 

$  2,818.62 

7 

do 

1,147-33 

10 

do 

1,064.87 

13 

do 

1,232.55 

16 

do 

1,463.24 

23 

do 

2,417-14 

26 

do 

1,283.84 

29 

do 

1,543-62 

3i 

do 

1,054.27 

Total  receit 

>ts  oer  cash  book.  

.    ..$13,925.48 

64  PUBLIC  ACCOUNTING  AND  AUDITING 

DISBURSEMENTS 

Jan.    i  Overdraft  on  Bank  $        10.32 

3  Sundry  checks  2,153.27 

7  do  1,427-83 

II  do  926.84 

15  do  853.87 

19  do  428.32 

23  do  647.83 

29  do  2,437.38 

31  Balance  as  shown  by  cash  book  5,029.82 

$13.92548 

Cash  on  hand  undeposited  amounted  to  $56.33. 

A  Petty  Cash  Fund  is  operated  on  the  Imprest  system. 

The  books  had  been  audited  to  the  3ist  of  December,  1911, 
and  the  fact  established  that  the  overdraft  of  $10.32  was  correct, 
after  all  checks  drawn  had  been  presented  and  paid  by  the  bank. 

The  deposits  in  the  bank  for  the  month  of  January,  as  shown 
by  the  bank  pass  book,  after  having  it  balanced  at  the  close  of 
business  January  31,  amounted  to  $13,854.37,  and  the  checks 
returned  by  the  bank  for  the  same  period  totaled  $8,832.34. 

There  were  checks  outstanding  at  the  time  of  balancing, 
January  31,  amounting  to  $53.27. 

Fraud  is  suspected  on  the  part  of  the  cashier,  and  you  are 
asked  to  check  the  transactions  recorded  by  him  as  shown  by 
the  cash  book.  Prepare  a  statement  showing  the  results  of 
your  investigations.  Your  statements  should  show  total  amount 
of  the  discrepancy.  Also  state,  with  reasons,  what  further 
documents  and  records  you  will  require,  if  any,  to  trace  the 
cash  transactions  fully.  C.  P.  A.  Ohio 

C.    LEGAL  QUESTIONS 

1.  Enumerate   the   methods  by  which   contracts  may  be 
discharged.  C.  P.  A.  Ohio. 

2.  What  is  your  understanding  of  the  term  "Legal  Tender"? 
Having  denned  this,  state  what  falls  within  that  designation  in 
this  country.  C.  P.  A.  111. 

3.  What  is  a  tender  to  perform  a  contract,  and  what  is  its 
effect?  Inst.  Ex.  1918. 

4.  Give  an  illustration  of  a  debt  or  claim  that  is  not  dis- 
chargeable  in  bankruptcy.  C.  P.  A.  Mich. 

5.     In  what  way  may  a  contract  be  discharged  by  operation 
of  law?  Inst.  Ex.  1918 


Chapter  Five 
NOTES  RECEIVABLE 

Having  completed  the  audit  of  the  Cash  account,  the  next 
account  to  be  taken  up  is  Notes  Receivable.  Notes  are  easily 
convertible  into  cash,  consequently  should  be  audited  on  the 
same  day  that  the  Cash  account  is  audited. 

1.    ACCOUNTING  THEORY. 

There  are  two  methods  of  recording  notes  and  drafts  receiv- 
able. The  first  method  is  to  record  them  in  the  general  journal 
and  to  keep  a  record  in  an  auxiliary  notes  receivable  book.  Under 
this  plan  the  notes  receivable  book  contains  a  memorandum 
record  only  and  does  not  constitute  a  posting  medium.  The 
notes  receivable  book  should  show  the  date  received,  drawer 
or  endorser,  maker  or  drawee,  payee,  where  payable,  due 
date,  amount,  rate  of  interest,  and  when  paid. 

The  second  method  is  to  record  notes  and  drafts  in  a  notes 
receivable  book  from  which  posting  is  to  be  done.  In  other 
words,  when  this  method  is  followed,  the  notes  receivable  book 
is  considered  a  book  of  original  entry  and  no  auxiliary  record 
is  kept.  This  book  differs  from  other  subdivisions  of  the 
journal  in  that  it  provides  for  considerably  more  information. 
All  the  information  provided  for  in  the  auxiliary  notes  receiva- 
ble book  explained  above,  is  also  provided  for  under  this  plan, 
and  in  addition,  columns  are  provided  to  enable  the  bookkeeper 
to  post  the  totals  to  the  proper  accounts  in  the  ledger.  The 
exact  arrangement  of  the  columns  will  depend  upon  the  system 
of  accounts  in  use.  The  notes  receivable  book  will  usually 
provide  for  a  Notes  Receivable  debit,  Interest  debit,  Interest 
credit,  Sales  Ledger  credit,  General  Ledger  debit  and  General 
Ledger  credit  columns.  The  important  thing  is  to  understand 
the  two  different  methods  of  recording  notes  and  drafts.  If 
recorded  in  the  general  journal,  then  the  entries  should  be  sup- 
ported by  memorandum  entries  in  an  auxiliary  notes  receivable 
book.  If  a  special  division  of  the  journal  is  to  be  used  for  re- 
cording transactions  involving  notes  receivable,  then  all  neces- 
sary information  may  be  recorded  in  it  and  posting  may  be 
done  direct  from  it. 

Notes  Receivable  Account.  If  the  first  method  explained 
above  is  followed,  then  the  Notes  Receivable  account  will  show 
the  individual  debits  and  credits  for  each  note  receivable 
recorded  in  the  books  of  account.  If  the  second  method  is 
pursued,  then  the  Notes  Receivable  account  will  be  in  the  nature 

65 


66  PUBLIC  ACCOUNTING  AND  AUDITING 

of  a  summary  or  controlling  account.  For  instance,  the  Notes 
Receivable  account  will  be  debited  only  for  the  total  of  the  notes 
receivable  debit  column  in  the  notes  receivable  book  and  may  be 
credited  for  the  total  of  the  notes  receivable  column  in  the  cash 
book,  depending  upon  whether  or  not  a  special  column  for 
notes  is  provided  on  the  debit  side  of  the  cash  book. 

Terminology.  The  term  "bills  receivable,"  is  frequently 
used  instead  of  "notes  receivable",  but  it  is  practically  universal 
in  practice  to  records,  notes  and  bills  or  drafts  in  the  same  ac- 
count. Some  bookkeepers  call  the  account  "bills  receivable"  while 
others  call  it  "notes  receivable".  The  term  "bills"  comes  from  the 
use  of  drafts  and  bills  of  exchange.  There  is  no  real  object  in  at- 
tempting to  separate  drafts  and  notes  in  the  books  of  account 
and,  to  do  so,  will  only  lead  to  confusion.  A  draft  accepted 
by  a  customer  is  a  "promise  to  pay"  just  as  much  as  a  pro- 
missory note  would  be.  Seymour  Walton,  *  C.  P.  A.,  says: 

"While  the  term  'bills  receivable'  is  almost  univer- 
sally understood,  it  would  perhaps  be  better  if  it  could 
be  replaced  by  the  more  accurately  descriptive  term 
'notes  receivable',  on  the  ground  that  in  this  country, 
when  a  person  gives  his  written  promise  to  pay  a  given 
amount,  the  document  is  invariably  referred  to  as  his 
note,  while  a  bill  is  the  creditor's  statement  in  writing, 
specifying  the  amount  and  character  of  his  claim  in 
detail". 

Trade  acceptances  are  becoming  quite  popular  with  busi- 
ness men.  The  question  often  arises  as  to  whether  or  not  a 
separate  account  should  be  kept  with  trade  acceptances.  In 
other  words,  should  they  be  separated  in  the  books  of  account 
from  notes  receivable.  There  can  be  no  real  reason  for  separating 
them  in  the  ordinary  business  except  where  the  volume  of  trade 
acceptances  is  large  and  it  is  desired  to  show  trade  acceptances 
as  a  separate  item  in  the  statements.  In  this  event,  separate 
accounts  can  be  kept  with  trade  acceptances  and  they  may  be 
recorded  in  the  general  journal,  or  a  special  journal  may  be 
provided. 

Notes  Receivable  Discounted.  A  question  arises  as  to 
the  best  method  of  recording  notes  receivable  discounted.  With 
a  great  number  of  bookkeepers,  it  is  common  practice  to  credit 
the  Notes  Receivable  account  at  the  time  of  discounting  a  note. 
This  has  been  criticised  by  accountants  because  of  the  fact 
that  before  a  note  can  be  discounted  it  must  be  endorsed,  and 
in  case  the  maker  fails  to  pay  the  note  at  maturity,  the  endorser 
becomes  liable,  consequently,  accountants  hold  that  this  lia- 
bility must  appear  in  the  statements.  It  is  considered  better 
practice  to  keep  a  separate  account  with  Notes  Receivable  Dis- 
counted, crediting  the  account  for  the  face  value  of  each  note 
or  draft  when  discounted  at  the  bank  and  debiting  it  with  the 

*From  his  text  on  "Auditing",  published  by  the  Alexander  Hamilton 
Institute. 


NOTES  RECEIVABLE  67 

face  value  of  each  note  or  draft  discounted,  when  paid  or  dis- 
honored by  the  maker  or  payee.  Of  course,  when  the  Notes 
Receivable  Discounted  account  is  debited,  the  Notes  Receivable 
account  would  be  credited.  In  order  to  verify  the  amount  of 
notes  receivable  on  hand,  it  is  necessary  to  deduct  the  balance 
of  the  Notes  Receivable  Discounted  account  from  the  balance 
of  the  Notes  Receivable  account. 

Contingent  Liability.  Notes  receivable  discounted  are  a 
contingent  liability  and  this  fact  should  be  indicated  in  the 
Balance  Sheet.  Kester  says: 

"For  this  reason,  whenever  a  business  house  trans- 
fers a  note  by  any  method  of  endorsement  (except  the 
qualified),  it  incurs  a  contingent  liability,  which  might 
become  a  real  liability  in  case  the  maker  of  the  note 
should  fail  to  meet  the  obligation  at  maturity.  Since  it 
is  the  function  of  good  accounting  to  present  all  the  facts 
bearing  on  the  welfare  of  the  business,  it  is  evident  that 
this  fact — that  of  incurring  a  contingent  liability — 
should  be  entered  in  the  books  of  account.  Very  fre- 
quently, however,  the  importance  of  this  matter  is  prac- 
tically ignored,  with  the  result  that  the  contingent  lia- 
bility item  is  lost  sight  of  altogether." 

2.    AUDITING  THEORY 

It  is  important  that  the  notes  be  counted  on  the  same  day 
that  the  cash  is  counted  for  the  reason  that,  like  cash,  they 
may  move  on  account  of  their  being  readily  convertible.  Analysis 
paper  is  usually  used  for  preparing  a  list  of  notes  receivable, 
on  account  of  the  amount  of  information  desired. 

Listing  the  Notes  Receivable 

(NOTE — Since  this  comprises  a  Balance  Sheet  audit  for 
credit  purposes,  we  will  quote  freely  from  the  Federal  Reserve 
Bulletin  of  April  1917.  That  Bulletin  was  termed  "Uniform 
Accounting"  and  was  intended  as  a  tentative  proposal  to  be 
adopted  by  manufacturing  and  merchandising  concerns). 
Quoting  from  the  Federal  Reserve  Bulletin: 

"A  list  of  notes  receivable  outstanding  at  the  end 
of  the  fiscal  period  should  be  prepared,  showing  the 
dates  the  notes  are  made,  the  customers'  names,  the  date 
due,  the  amounts  of  the  notes  and  the  interest,  if  any, 
contained  in  the  notes.  If  discounted,  the  name  of  the 
discounting  bank  should  be  noted  and  verification  ob- 
tained from  the  bank. 

"The  outstanding  notes  must  be  carefully  examined 
with  the  notes  receivable  book,  and  with  the  list  pre- 
pared by  or  produced  to  the  auditor,  the  due  dates  and 
the  dates  of  making  the  notes  being  carefully  checked, 
and  when  notes  have  been  renewed  the  original  dates 


68  PUBLIC  ACCOUNTING  AND  AUDITING 

should  be  recorded.  When  notes  have  been  paid  since 
the  close  of  the  fiscal  year,  the  cash  should  be  traced  into 
the  books  of  the  company,  and,  when  they  are  in  the 
hands  of  attorneys  or  bankers  for  collection,  certificates 
should  be  obtained  from  the  depositaries. 

"When  notes  receivable  are  discounted  by  banks, 
the  company  has  a  liability  therefor  which  should  appear 
on  the  Balance  Sheet.  Lists  of  discounted  notes  not 
matured  at  the  date  of  the  audit  should  be  obtained  from 
the  banks  as  verification  and  their  totals  entered  under 
secured  liabilities  if  the  cash  therefor  is  shown  as  an 
asset. 

"The  value  of  collateral,  if  any,  held  for  notes 
should  be  ascertained,  as  it  frequently  happens  that  the 
notes  are  worth  no  more  than  the  collateral. 

"Notes  due  by  officials  and  employees  must  always 
be  stated  separately  from  customers'  notes,  as  must  also 
notes  received  for  other  than  trade  transactions. 

"Notes  due  from  affiliated  concerns  must  not  be 
included  as  customers'  notes,  even  though  received  as 
a  result  of  trading  transactions.  Affiliated  companies' 
notes  should  be  shown  as  a  separate  item  of  current 
assets  or  as  other  assets  as  the  circumstances  warrant. 
They  may  be  fairly  included  in  current  assets  if  the 
debtor  company  has  ample  margin  of  quick  assets  over 
its  liabilities,  including  such  notes." 

3.    AUDITING  PROCEDURE 

While  one  of  the  juniors  counted  the  cash,  the  other  junior 
prepared  a  list  of  the  notes  receivable  owned  by  the  Blank 
Manufacturing  Company  as  at  December  31,  1918.  The 
Federal  Reserve  Bulletin  stipulates  that  only  a  list  should  be 
made  of  the  notes  receivable  outstanding  at  the  end  of  the  fiscal 
period,  but  it  is  believed  to  be  better  practice  to  make  a  complete 
list  of  all  the  notes  receivable,  whether  on  hand  or  outstanding 
for  the  reason  that  the  information  will  be  of  value  later  on 
when  calculating  the  accrued  interest  and  in  case  any  discrep- 
ancies are  noted.  Reference  to  the  illustration  on  page  69 
will  show  the  junior's  working  sheet  on  which  he  prepared  a 
list  of  the  notes  receivable. 

Reference  to  page  51  will  show  that  the  management 
had  estimated  that  2%  of  the  notes  receivable  will  prove 
worthless.  Investigation  shows  that  this  estimate  is  based  on 
previous  experience.  However,  a  reserve  of  this  kind  would 
not  be  a  permissible  deduction  on  an  income  tax  return,  only 
actual  losses  within  the  year  being  allowed.  Where  experience 
and  investigation  show  that  beyond  a  doubt  there  will  be  a 
certain  per  cent  of  notes  prove  worthless,  then  it  is  sound  ac- 
counting to  set  up  a  reserve.  This  will  be  discussed  further 
in  a  later  chapter. 


NOTES  RECEIVABLE 


69 


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70  PUBLIC  ACCOUNTING  AND  AUDITING 

SECURITIES 

Securities  like  notes  receivable  should  be  audited  as  soon 
as  possible  after  the  beginning  of  the  audit  and  if  possible,  on 
the  same  day  that  the  cash  is  counted. 

1.    ACCOUNTING  THEORY 

Investments  are  of  two  classes,  speculative  and  non-specu- 
lative. When  securities  are  purchased  with  the  intention  of 
holding  them  until  such  time  as  the  market  value  may  increase 
and  enable  the  holder  to  sell  at  a  profit,  the  investment  is.  to 
be  considered  speculative.  But  when  securities  are  purchased 
and  held  because  of  the  income  they  produce,  the  investment 
is  non-speculative. 

Accounting  for  Speculative  Investments.  When  se- 
curities are  purchased  either  on  a  margin  or  by  payment  in 
full  with  the  expectation  of  selling  at  any  time  when  the  market 
price  is  favorable,  the  investment  is  made,  not  because  of  the 
income  the  securities  will  produce,  but  because  of  the  expecta- 
tion of  making  a  profit  through  a  sale.  In  other  words,  these 
securities  in  a  sense  become  the  stock-in-trade  of  the  investor 
and  like  any  other  stock-in-trade  should  be  recorded  at  cost. 
An  account  may  be  opened  with  each  class  of  security  purchased 
or  a  summary  account  may  be  opened  with  Securities  and  a 
subsidiary  record  may  be  kept.  The  cost  price  of  these  securi- 
ties includes  broker's  fees  and  any  other  expenses  in  connection 
with  the  purchase  of  the  stock.  To  record  these  investments 
at  their  par  value  is  wrong  because  it  anticipates  a  profit  or 
a  loss  at  the  time  of  the  purchase,  when  in  reality  the  profit 
or  loss  is  realized  only  at  the  time  of  sale. 

Accounting  for  Non-Speculative  Investments.  Non- 
speculative  investments  are  of  two  kinds:  Those  intended  as 
temporary  producers  of  income  and  those  intended  to  be  held 
until  maturity.  The  latter  are  to  be  considered  as  permanent 
investments. 

Temporary  Investments.  Investments  intented  as  tem- 
porary producers  of  income  should  undoubtedly  be  recorded  at 
cost  price  and  should  be  carried  on  the  books  at  the  market  price 
at  the  time  of  the  purchase.  It  is  not  possible  to  scientifically 
amortize  the  discount  or  premium  on  such  securities  because 
it  is  not  known  how  long  they  will  be  held,  and  since  it  is  not 
the  intention  of  the  investors  to  hold  these  securities  until 
maturity,  it  will  readily  be  seen  that  the  only  thing  to  do  is 
to  debit  the  account  with  Securities  at  actual  cost  price.  When 
interest  is  collected  it  should  be  credited  to  an  account  with 
Interest  on  Investments.  It  is  this  account  that  indicates  the 
amount  of  the  income  from  the  investment  during  the  period. 


SECURITIES  71 

In  case  the  securities  are  sold  at  a  profit  or  loss,  there  are 
two  methods  of  procedure:  the  first  is  to  credit  the  Securities 
account  at  the  selling  price  regardless  of  what  it  may  be.  The 
difference  between  the  cost  price  and  the  selling  price  of  the 
securities  would  be  the  amount  of  profit  or  loss  and  is  either 
an  addition  to  or  a  deduction  from  income  in  the  Profit  and 
Loss  statement.  The  second  method  is  to  credit  the  account 
with  Securities  with  the  cost  price  and  to  debit  or  credit  a  nominal 
account  for  the  profit  or  loss  resulting  from  the  sale.  The  latter 
practice  is  to  be  commended  because  it  distinguishes  between 
real  and  nominal  accounts.  This  is  the  same  method  of  account- 
ing as  is  advocated  in  connection  with  the  sale  of  fixed  assets. 

Permanent  Investments.  There  is  a  lack  of  uniformity 
in  regard  to  the  method  of  recording  permanent  investments. 
The  accounting  procedure  becomes  more  complicated  when 
securities  are  purchased  with  the  intention  of  holding  them 
until  maturity.  These  securities  may  be  recorded  either  at 
cost  price  or  at  their  par  value.  If  they  are  recorded  at  par, 
separate  accounts  should  be  carried  for  the  discount  or  premium 
and  another  account  for  the  interest.  If  the  securities  are 
recorded  at  cost,  no  separate  accounts  with  Discount  and  Prem- 
ium need  be  opened,  but  an  account  with  Interest  is  kept  to 
show  the  income. 

Amortization  of  Bond  Discount  and  Premium.     If 

the  bonds  are  recorded  at  par  value,  an  account  with  Discount 
and  Premium  is  charged  or  credited  with  the  difference  between 
the  cost  price  and  the  par  value.  This  account  should  then 
be  amortized  over  the  life  of  the  bonds.  There  are  two  methods 
for  making  this  distribution.  These  are  known  as  the  "straight 
line"  and  the  "scientific"  methods. 

Straight  Line  Method.  The  straight  line  method  con- 
sists in  dividing  the  amount  of  premium  by  the  interest  periods 
the  bonds  have  to  run,  the  quotient  being  the  amount  to  be 
amortized  periodically.  This  method  commends  itself  because 
of  its  simplicity  and  ease  of  operation  but  it  is  not  scientifically 
correct. 

Scientific  Method.  The  scientific  method  is  based  upon 
compound  interest  calculations,  the  premium  being  looked  upon 
as  the  amount  of  the  present  worth  of  the  annuity,  taking  into 
consideration  the  rate  of  interest  and  the  time  in  interest  periods 
the  bond  has  to  run. 

The  scientific  method  is  the  better  one  as  the  interest  is 
not  overstated  in  the  first  periods  as  would  be  the  case  with 
the  straight  line  method.  However,  the  straight  line  method 
is  allowed  by  the  Department  of  Banking  of  the  state  of  New 
York  for  valuing  the  investments  of  saving  banks. 


72  PUBLIC  ACCOUNTING  AND  AUDITING 

Accounting  for  Sinking  Fund  Investments.  There 
are  three  classes  of  entries  in  connection  with  accounting  for 
sinking  funds. 

1.  (a)  Those   relating   to   the   original   payments   to   the 
sinking    fund    trustee;   and    (b)    those   relating    to    subsequent 
payments  to  the  sinking  fund  trustee. 

2.  Those  relating  to  the  transactions  consummated  by  the 
trustee.    These  entries  are  recorded  at  the  time  of  the  trustee's 
periodic  report. 

3.  Those  relating  to  the  redemption  of  the  debt  and  the 
final  disposition  of  the  accounts  relating  to  the  sinking  fund. 

The  usual  plan  is  to  create  a  reserve  out  of  profits  equal 
to  the  amount  of  the  sinking  fund.  The  funds  are  placed  in 
the  hands  of  a  trustee  for  investment.  The  income  from  the 
trustee's  investments  is  usually  considered  an  addition  to  the 
fund.  The  following  are  illustrative  of  the  three  classes  of 
entries  explained  above : 

First  Class.  At  the  time  the  original  payments  are  made 
to  the  trustee,  two  entries  are  required. 

1.  Sinking  Fund  Trustees xxxxx.xx 

Cash xxxxx . xx 

To  record  original  payment 
to  sinking  fund  trustee — sinking 
fund  being  created  according  to 
terms  of  trust  agreement  to  retire 
the  first  mortgage  bonds  of  the 
company. 

2.  Surplus xxxxx.xx 

Sinking  Fund  Reserve xxxxx.xx 

To  set  up  a  reserve  out  of  profits 
to  provide  funds  for  the  redemp- 
tion of  bonds. 

All  subsequent  payments  to  the  sinking  fund  trustee  should 
be  recorded  in  exactly  the  same  manner  as  the  original  payments. 

Second  Class.  Upon  receipt  of  the  trustee's  report,  it 
would  be  necessary  to  set  up  entries  for  all  completed  transac- 
tions of  the  trustee.  These  may  include  purchase  of  securities, 
collection  of  interest  on  securities,  sale  of  securities,  expenses 
incurred,  etc.  The  trustee  may  purchase  securities  at  a  discount 
or  premium,  in  which  case  the  transaction  involves  the  proper 
treatment  of  such  discounts  and  premiums.  This  has  already 
been  discussed  at  some  length  and  the  same  principles  apply 
to  sinking  fund  accounting  as  to  general  accounting.  Assuming 
that  bonds  purchased  by  the  trustee  are  to  be  recorded  at  par 
the  following  entry  shows  the  proper  procedure: 


SECURITIES  73 

Sinking  Fund  Bonds xxxxx.xx 

Sinking  Fund  Income  (Accrued  Int.)..  .  xxxxx.xx 

Sinking  Fund  Trustee xxxxx.xx 

Sinking  Fund  Income  (Discount)..  xxxxx.xx 

To  record  the  purchase  of  bonds  with 

accrued  interest  at  less  than  the  par 

value. 

If  the  bonds  have  been  purchased  at  a  premium,  the  Sinking 
Fund  Income  account  should  be  debited  for  the  amount  of 
such  premium.  The  Sinking  Fund  Income  account  should  be 
debited  for  accrued  interest  at  the  time  of  the  purchase  of 
bonds,  for  the  premium  when  bonds  are  bought  above  par, 
and  for  expenses  in  connection  with  the  sinking  fund.  The 
account  should  be  credited  for  discount  on  bonds  purchased 
below  par  and  for  interest  collected  on  the  bonds.  Of  course, 
separate  accounts  may  be  kept  with  Sinking  Fund  Income 
and  Sinking  Fund  Expense,  if  desired.  At  the  end  of  each 
year  the  Sinking  Fund  Income  and  Expense  accounts  should 
be  closed  into  Profit  and  Loss.  This  profit  and  loss,  of  course, 
will  later  be  closed  into  the  Surplus  account.  The  following 
entry  is  illustrative: 

Sinking  Fund  Income xxxxx.xx 

Profit  and  Loss xxxxx .  xx 

To  close  the  net  amount  of  the  In- 
come from  the  Sinking  Fund  into 
Profit  and  Loss. 

If  the  trustee  purchases  the  company's  own  bonds,  which 
is  often  done,  there  is  practically  no  difference  in  recording 
the  transaction.  If  the  bonds  are  cancelled  at  the  time  of  their 
purchase,  the  debit  would  be  to  the  Bond  account  of  the  com- 
pany instead  of  to  Sinking  Fund  Bonds. 

Third  Class.  When  the  bonds  for  which  the  sinking  fund 
is  created  mature,  the  securities  of  the  trustee  must  be  converted 
into  cash  to  be  used  for  redeeming  the  bonds.  Various  entries 
may  be  required  depending  upon  the  transactions.  The  follow- 
ing are  illustrative: 

1.  Sinking  Fund  Trustee xxxxx.xx 

Sinking  Fund  Bonds xxxxx.xx 

To  record  sale  of  bonds  in  the 
Sinking  Fund. 

2.  First  Mortgage  6%  Bonds xxxxx.xx 

Sinking  Fund  Trustee xxxxx.xx 

To  record  redemption  of  bonds. 

3.  Cash xxxxx .  xx 

Sinking  Fund  Trustee xxxxx.xx 

To  record    transfer   of   cash    in 
hands  of  trustee  to  the  company. 


74  PUBLIC  ACCOUNTING  AND  AUDITING 

If  the  bonds  have  been  redeemed  and  cancelled,  and  the 
trustee  has  transferred  the  balance  of  cash  back  to  the  company 
the  only  thing  left  to  be  done  is  the  closing  of  the  Sinking  Fund 
Reserve  account  into  the  Surplus  account.  This  addition  to 
surplus  is  available  for  dividends. 

2.    AUDITING  THEORY 

Quoting  from  the  Federal  Reserve  Bulletin: 

Listing  the  Securities 

"Under  this  caption  must  be  listed  securities  in 
which  surplus  funds  of  the  company  or  firm  have  been 
temporarily  invested  and  which  are  considered  avail- 
able as  'quick  assets',  i.  e.,  can  be  turned  into  money 
in  time  of  need.  Where  stocks  or  bonds  represent  con- 
trol or  a  material  interest  in  other  enterprises,  the 
ownership  of  which  carries  more  or  less  value  to  the 
holder  outside  of  the  return  thereon,  they  should  be 
considered  as  fixed  assets. 

"A  list  of  investments  should  be  prepared  showing — 

The  dates  of  purchases. 

Descriptions  of  the  investments. 

Par  value  of  the  investments. 

The  denomination  of  the  shares. 

The  number  of  shares  or  bonds  owned. 

The  total  capital  stock  of  the  various  com- 
panies. 

The  amounts  paid  for  the  investments. 

The  interest  and  dividends  received. 

The  market  values  of  the  investments. 

The  surplus  or  deficit  shown  by  the  Balance 
Sheets  of  the  companies  where  no  market 
quotations  are  available. 

If  hypothecated,  with  whom  and  for  what  pur- 
pose. 

"This  list  must  be  compared  with  the  ledger  ac- 
counts concerned,  and  the  total  of  amounts  paid  accord- 
ing to  the  list  must  agree  with  the  balance  of  the  invest- 
ment account  or  accounts. 

"The  securities  must  be  examined  by  the  auditor 
in  person  or  he  must  secure  confirmation  of  their  ex- 
istence from  those  who  hold  them  as  collateral.  Those 
in  possession  of  the  company  must  be  counted  and 
examined  as  soon  as  possible  after  the  audit  starts,  and 
all  of  them  must  be  submitted  to  him  at  one  time.  It 
is  much  more  satisfactory  to  see  the  actual  securities 


SECURITIES  75 

than  to  verify  cash  receipts  and  other  evidences  there- 
for after  the  audit  has  progressed  some  time. 

"Certificates  out  for  transfer  must  be  verified  by 
correspondence. 

"Where  the  market  values  of  securities  are  less  than 
the  book  values,  save  where  the  variation  is  so  small  as 
to  be  trifling,  a  reserve  for  loss  in  value  on  the  Balance 
Sheet  date  must  be  set  up. 

"Care  must  be  taken  to  see  that  the  certificates 
are  made  out  in  favor  of  the  company,  or  that  they  are 
endorsed  or  accompanied  by  powers  of  attorney  when 
they  are  in  the  names  of  individuals. 

"Coupons  on  bonds  must  be  examined  to  see  that 
they  are  intact  subsequent  to  the  latest  interest  pay- 
ment date. 

"The  investment  schedule  must  show  that  the 
total  interest  and  dividends  receivable  by  the  company 
have  been  duly  accounted  for;  the  income  from  the  in- 
vestments shown  in  the  Profit  and  Loss  account  must 
be  in  accord  with  this  schedule. 

"When  market  quotations  cannot  be  obtained  for 
investments,  the  Balance  Sheets  of  the  companies  in 
which  investments  are  held  must  be  examined  so  that 
the  auditor  may  form  an  idea  of  their  value. 

"In  verifying  purchases  of  stock  exchange  securi- 
ties the  brokers'  advices  must  in  all  cases  be  examined 
in  connection  with  the  verification  of  the  purchase  price. 

"Investments  in  deeds  and  mortgages  must  be  sup- 
ported by  both  the  mortgages  and  insurance  policies, 
and,  furthermore,  it  must  be  shown  that  all  assessed 
taxes  on  the  property  have  been  duly  paid,  that  the 
mortgages  have  been  properly  recorded,  and  that  the 
insurance  policies  are  correctly  made  out  to  the  com- 
pany. 

"If  any  of  the  securities  have  been  hypothecated 
the  fact  and  amount  (book  value)  must  be  stated  under 
secured  liabilities  on  the  Balance  Sheet." 

An  inexperienced  junior  must  be  very  careful  in  auditing 
securities  because  of  the  fact  that  he  is  likely  to  be  unfamiliar 
with  the  work  and  in  his  attempt  to  conceal  his  ignorance, 
will  likely  make  errors  that  he  would  not  otherwise  make.  Take 
all  the  time  necessary  to  count  the  securities  and  prepare  lists 
of  them.  Don't  let  anything  or  anybody  interfere  with  your 
work,  and  don't  stop  until  you  know  that  you  have  a  complete 
record  of  all  securities  held  by  the  client,  as  well  as  a  record  of 
those  outstanding,  whether  in  the  hands  of  the  banks,  stock 
brokers  or  out  to  be  recorded.  All  these  can  be  counted  and 
checked  with  the  list  later. 


76  PUBLIC  ACCOUNTING  AND  AUDITING 

3.    AUDITING  PROCEDURE 

While  the  juniors  were  at  work  on  the  first  day  of  the 
audit,  the  senior  accountant  counted  and  listed  the  securities. 
Reference  to  the  Trial  Balance  will  show  that  the  only  securi- 
ties that  are  involved  will  be  found  in  connection  with  the  ac- 
counts, Sinking  Fund  and  Investment  of  Surplus. 

The  surplus  was  found  to  be  invested  in  4%%  Liberty  Bonds 
on  May  9,  1918,  being  a  part  of  the  Third  Liberty  Loan,  the 
interest  on  these  bonds  falls  due  on  March  15  and  September  15 
each  year.  These  were  counted  and  there  were  found  to  be 
ten  $1,000  Bonds  with  all  coupons,  not  yet  due,  attached. 

Verification  of  the  sinking  fund  revealed  that  on  January 
2,  1918,  there  was  set  aside  $15,000  in  cash  and  deposited  with 
the  Merchants  National  Bank,  who  has  been  named  as  trustee 
for  the  fund.  This  is  in  agreement  with  the  bondholders  and 
it  is  understood  that  the  President  of  the  Merchants  National 
Bank  may  invest  this  surplus  in  first  real  estate  mortgages, 
paying  not  less  than  6%  interest,  and  the  amount  of  the  mort- 
gage is  in  no  event  to  exceed  two  thirds  of  the  appraisal  value 
of  the  real  estate.  After  going  over  the  matter  with  the  Presi- 
dent of  the  bank,  it  was  found  that  the  entire  sum  had  been 
loaned  to  Harrison  G.  Matthews.  A  first  mortgage  was  obtained 
dated  January  10,  1918,  with  interest  at  6%  payable  annually, 
and  is  based  on  city  property  valued  at  $25,000.  This  valuation 
being  the  basis  for  taxes.  The  loan  is  evidenced  by  a  note 
secured  by  a  first  mortgage  on  the  property. 

THE  LAW  OF  NEGOTIABLE  INSTRUMENTS 

Some  contracts  are  "assignable"  while  others  are  "nego- 
tiable." We  shall  discuss  here  those  conditions  which  make 
a  contract  negotiable.  A  negotiable  contract  is  usually  spoken 
of  as  a  "negotiable  instrument."  There  are  three  principal 
classes  of  negotiable  instruments — notes,  drafts  and  checks. 
It  is  essential  that  the  accountant  understand  the  essentials 
of  negotiable  instruments,  hence  the  following  discussion  is 
based  upon  the  essentials  and  non-essentials  as  stated  in  the 
Negotiable  Instruments  Law.* 

Essentials  of  Negotiability.  An  instrument  to  be 
negotiable  must  conform  to  the  following  requirements: 

1.  Must  be  in    writing    and    signed    by    the    maker    or 
drawer. 

2.  Must  contain   an   unconditional   promise  or  order   to 
pay  a  sum  certain  in  money. 

*The  Negotiable  Instruments  Law  is  a  statute  which  was  prepared  by 
a  commission  on  Uniform  State  Laws  to  modify  and  make  uniform  the  Law 
of  Negotiable  Instruments  throughout  the  United  States.  For  the  most 
part,  it  modifies  the  preexisting  law.  This  law  has  been  adopted  without 
important  amendments  by  all  the  states  and  the  District  of  Columbia. 


THE  LAW  OF  NEGOTIABLE  INSTRUMENTS  77 

3.  Must  be  payable  on  demand,  or  at  a  fixed  or  deter- 
minable  future  time. 

4.  Must  be  payable  to  order  or  to  bearer;  and 

5.  Where  the  instrument  is  addressed  to  a  drawee,  he 
must  be  named  or  otherwise  indicated  therein  with  reasonable 
certainty. 

Additional    Provisions    Not    Affecting    Negotiability. 

An  instrument  which  contains  an  order  or  promise  to  do  any 
act  in  addition  to  the  payment  of  money  is  not  negotiable. 
But  the  negotiable  character  of  an  instrument  otherwise  nego- 
tiable is  not  affected  by  a  provision  which: 

1.  Authorizes  the  sale  of  collateral  securities  in  case  the 
instrument  is  not  paid  at  maturity;    or 

2.  Authorizes  a  confession  of  judgment  if  the  instrument 
be  not  paid  at  maturity;  or 

3.  Waives  the  benefit  of  any  law  intended  for  the  advan- 
tage or  protection  of  the  obligor;   or 

4.  Gives  the  holder  an  election  to  require  something  to 
be  done  in  lieu  of  payment  of  money. 

But  nothing  in  this  section  shall  validate  any  provision 
or  stipulation  otherwise  illegal. 

Non-essentials  to  Negotiability.  The  validity  and 
negotiable  character  of  an  instrument  are  not  affected  by  the 
fact  that: 

1.  It  is  not  dated;  or 

2.  Does  not  specify  the  value  given,  or  that  any  value 
has  been  given  therefor;  or 

3.  Does  not  specify  the  place  where  it  is  drawn  or  the 
place  where  it  is  payable. 

When  Date  May  Be  Inserted.  Where  an  instrument 
expressed  to  be  payable  at  a  fixed  period  after  date  is  issued 
undated,  or  where  the  acceptance  of  an  instrument  payable  at 
a  fixed  period  after  sight  is  undated  any  holder  may  insert 
therein  the  true  date  of  issue  or  acceptance,  and  the  instrument 
shall  be  payable  accordingly.  The  insertion  of  a  wrong  date 
does  not  avoid  the  instrument  in  the  hands  of  a  subsequent  holder 
in  due  course,  but  as  to  him,  the  date  so  inserted  is  to  be  regarded 
as  the  true  date. 

When  Blanks  May  Be  Filled  In.  Where  the  instru- 
ment is  wanting  in  any  material  particular,  the  person  in  posses- 


78  PUBLIC  ACCOUNTING  AND  AUDITING 

sion  thereof  has  a  prima  facie  authority  to  complete  it  by  filling 
up  the  blanks  therein.  And  a  signature  on  a  blank  paper  de- 
livered by  the  person  making  the  signature  in  order  that  the 
paper  may  be  converted  into  a  negotiable  instrument  operates 
as  a  prima  facie  authority  to  fill  it  up  as  such  for  any  amount. 
In  order,  however,  that  any  such  instrument,  when  completed, 
may  be  enforced  against  any  person  who  became  a  party  thereto 
prior  to  its  completion,  it  must  be  filled  up  strictly  in  accordance 
with  the  authority  given  and  within  a  reasonable  time.  But 
if  such  instrument,  after  completion,  is  negotiated  to  a  holder 
in  due  course,  it  is  valid  and  effectual  for  all  purposes  in  his 
hands,  and  he  may  enforce  it  as  if  it  had  been  filled  up  strictly 
in  accordance  with  the  authority  given  and  within  a  reasonable 
time. 

When  Provisions  Conflict 

1.  Where    there  is  a  conflict    between    the  written  and 
printed   provisions  of  the  instrument,   the  written  provisions 
prevail. 

2.  Where  the  sum   payable  is  expressed   in  words  and 
also  in  figures  and  there  is  a  discrepancy  between  the  two,  the 
sum  denoted  by  the  words  is  the  sum  payable. 


A.  THEORY  QUESTIONS 

1.  In  examining  securities,  what  data  should  be  recorded 
to  protect  the  auditor?    What  is  to  be  apprehended?    C.  P.  A. 
Ohio. 

2.  A  concern  has  established  a  sinking  fund  for  the  retire- 
ment of  a  mortgage.     An  investment  has  been  made  in  bonds  the 
present  market  value  of  which  is  below  cost.     Would  you  inven- 
tory them  at  market  value  or  at  book  value?  Why?  C.  P.  A.  Mich. 

3.  Your  verification  of  the  securities  of  a  corporation  has 
to  be  made  at  a  date  about  two  months  subsequent  to  the  date 
of  the  Balance  Sheet  you  are  asked  to  certify.    Can  you  suggest 
steps  which  will  enable  you  to  do  this  without  risk  of  overlook- 
ing serious  overstatement?  Inst.  Ex.  1918. 

4.  Describe  two  different  methods  for  writing  off  the  pre- 
miums on  bonds  and  state  which,  in  your  opinion,  is  the  best 
method.  Inst.  Ex.  1917. 

5.  In  auditing  a  trust  company's  accounts,  you  find  that 
the  company  is  cotrustee  for  a  number  of  estates.    The  securi- 
ties are  locked  in  a  safe  deposit  box  that  cannot  be  opened 
without  the  assistance  of  the  absent  trustee,  who  will  be  away 
for  several  months.    What  precautions  should  be  taken  to  safe- 
guard the  integrity  of  your  audit?  C.  P.  A.  N.  Y. 


ACCOUNTING  PROBLEMS  79 

B.    ACCOUNTING  PROBLEMS 

1.  State  in  form  of  journal  entries  on  books  of  John  Brown 
the  following  transactions: 

(a)  Installment  notes  given  by  him  on  purchase  of  real 
estate;     face  of  notes  includes  interest  charges  up  to  and  in- 
cluding maturity  of  notes. 

(b)  Note  of  John  Jones  returned  from  the  bank  with  a 
protest  charge  after  having  been  left  for  collection. 

C.  P.  A.  Ark.  and  Me. 

2.  The   Oak   Furniture   Company  placed  $50,000  of  its 
undivided  earnings  in  the  hands  of  a  broker  to  invest  in  United 
States  4%  bonds.    The  bonds  were  $1,000  each  and  cost  101  %, 
commission  %.     Prepare  journal  entries  to  record  properly  the 
transaction  on  the  company's  books.  C.  P.  A.  N.  Y. 

3.  Give  examples  of  the  proper  entries  when  the  following 
transactions  occur  in  respect  to  Notes  Receivable: 

1 .  When  a  note  is  received. 

2.  When  a  note  is  discounted. 

3.  When  a  note  is  paid. 

4.  When  a  note  is  partly  paid  and  a  new  note  given 

for  the  balance. 

5.  When  a  note  is  collected  by  the  bank. 

6.  When  a  note  is  protested.  C.  P.  A.  Mich. 

4.  A   company  is   under  obligations   to   pay  $10,000   to 
sinking  fund  trustees  "out  of  profits".     The  following  trans- 
actions take  place: 

I9i4-Dec.  31.  $10,000  cash  paid  to  sinking  fund  trus- 
tees. 

I9i5-Jan.  5.  Trustees  invest  $10,000  of  the  5% 
bonds  of  the  company  at  ninety- 
eight  and  interest  (from  January  I.) 

July     i.     Coupons  on  above  bonds  collected. 
Dec.  31.     $10,000  paid  to  sinking  fund  trustees. 

I9i6-Jan.     I.     Coupons  collected. 

2.     $i  1,000  bonds  bought  for  sinking  fund 
at  ninety-five. 

July     i.     Coupons  collected. 

Dec.  31.     $125  paid  for  expenses  of  sinking  fund. 
31.     $10,000  paid  to  sinking  fund  trustees. 

1917— Jan.      I-     Coupons  collected. 

10.     $10,000  bonds  bought  at  one  hundred 
and  one  and  interest. 

Give  the  journal  entries  on  the  company's  books  for  the 
above  transactions.  Inst.  Ex.  1917- 


8o  PUBLIC  ACCOUNTING  AND  AUDITING 

C.     LEGAL  QUESTIONS 

1.  State  all  the  essential  legal  requirements  of  a  contract 
constituting  a  valid  negotiable  note.  Inst.   Ex.    1917. 

2.  A  executes  and  delivers  to  B  an  undated  negotiable 
note,  payable  60  days  after  date.     B  inserts  a  wrong  date  (not 
the  date  of  delivery)  and  the  note  passes  in  due  course  to  C. 
What  is  the  effect  of  the  insertion  as  to  the  maturity  of  note 
as  to  C?    Does  it  avoid  the  instrument  in  his  hands? 

Inst.  Ex.  1918. 

3.  Under  the  Negotiable  Instrument  Law: 

(a)  If  there  is  a  conflict  between  the  written  and  printed 
provisions  in  a  note,  which  one  controls? 

(b)  Where  there  is  a  discrepancy  between  the  words  and 
figures  in  a  note,  which  one  controls? 

C.  P.  A.  Mich. 

4.  New  York,  October  i,  1917 
One  month  after  date  I  promise  to  pay  John  Smith  Five 

Hundred   Dollars  for  value  received,   negotiable  and  payable 
without  defalcation  or  discount. 

(Signed)  Henry  Jones. 
Is  the  above  note  negotiable  or  not?     Give  reasons. 

Inst.  Ex.  1917 

5.  Are  the  following  notes  negotiable  or  not?    Give  reasons. 

(a)  No  date,  nor  place. 
I  promise  to  pay  bearer  One  Hundred  Dollars. 

(Signed)     A.  B. 

(b)  January  5,  1917. 
Due  A.  B.  or  order  on  demand  One  Hundred  Dollars. 

(Signed)     C.  D. 

(c)  Chicago,    Sept.    5,    1916. 
On  or  before  Dec.  I,  1916,  I  promise  to  pay  to  C.  D.  or 

order  One  Hundred  Dollars. 

(Signed)  A.  B. 

(d)  New  York,  April   10,   1916. 
On I  promise  to  pay  to  the  order  of  C.   D. 

One  Hundred  Dollars. 

(Signed)     A.  B. 
Inst.  Ex.  1917. 


Chapter  Six 
ACCOUNTS  RECEIVABLE 

Reference  to  the  Trial  Balance  on  page  50  of  Chapter  Four 
will  show  that  the  amount  of  accounts  receivable  on  December 
31,  1918,  taken  from  the  books  of  the  Blank  Manufacturing 
Company,  is  $81,687.00. 

1.    ACCOUNTING  THEORY 

The  Sales  Ledger.  While  accounts  with  customers  may 
be  kept  in  the  general  ledger,  it  is  usually  better  practice  to  keep 
a  subsidiary  ledger  containing  only  the  accounts  with  trade  cus- 
tomers. Different  titles  as  applied  to  such  a  ledger  were  discussed 
in  Chapter  Three,  page  36.  It  is  important  that  only  trade  cus- 
tomers' accounts  be  kept  in  this  ledger.  Any  accounts  with 
officers,  stockholders  or  employees  should  be  kept  in  the  general 
ledger  and  should  be  listed  on  the  Balance  Sheet  as  a  separate 
item.  Under  no  circumstances,  should  such  accounts  be  included 
with  accounts  receivable. 

The  Sales  Ledger  Controlling  Account.  If  a  subsidiary 
ledger  is  kept  with  customers,  it  will  be  necessary  to  keep  a  con- 
trolling account  in  the  general  ledger.  The  purpose  of  such  an 
account  is  to  show  the  total  amount  due  from  customers  without 
the  necessity  of  preparing  a  schedule  of  all  accounts  in  the  sales 
ledger. 

To  establish  a  subsidiary  sales  ledger  and  a  controlling 
account  in  the  general  ledger,  assuming  that  customers'  accounts 
have  previously  been  kept  in  the  general  ledger,  make  a  journal 
entry  as  follows: 

Sales  Ledger xxxxx .  xx 

Accounts  with  customers xxxxx. xx 

To  establish  a  subsidiary  ledger  for 
accounts  with  trade  customers.  See 
schedule  of  customers'  accounts  following: 
(There  should  follow  a  schedule  of  all  cus- 
tomers' accounts  showing  balances  due.) 

81 


82  PUBLIC  ACCOUNTING  AND  AUDITING 

The  Sales  Ledger  account  should  be  debited  with  the  total 
amount  due  on  account  from  customers  and  each  account  in  the 
sales  ledger  should  be  debited  for  the  balance  due.  At  the  same 
time,  each  customer's  account  in  the  general  ledger  should  be 
credited  with  the  balance  due.  Note  that  the  debit  entry  is  really 
posted  twice:  First,  in  one  sum  to  the  debit  of  the  controlling 
account  in  the  general  ledger;  second,  to  the  debit  of  each  cus- 
tomer's account  in  the  sales  ledger,  in  amount  as  shown  on  the 
schedule  of  accounts  receivable.  Since,  however,  the  sales  ledger 
is  considered  a  subsidiary  ledger  and  will  not  necessarily  be 
taken  into  consideration  when  preparing  a  Trial  Balance,  the 
double  posting  of  the  debit  item  will  not  affect  the  equilibrium 
of  the  general  ledger.  After  the  entry  has  been  properly  posted 
all  customers'  accounts  in  the  general  ledger  will  be  in  balance, 
but  each  account  in  the  sales  ledger  will  show  balance  due  on 
account.  The  Sales  Ledger  account  in  the  general  ledger  will 
show  the  total  amount  due  from  customers. 

Accounts  with  customers  in  the  sales  ledger  are  debited  and 
credited  with  the  individual  transactions  in  the  same  manner  as 
though  they  were  a  part  of  the  general  ledger.  In  other  words, 
all  transactions  recorded  in  any  of  the  books  of  original  entry 
which  affect  a  customer's  account  will  be  posted  to  the  customer's 
account  in  the  sales  ledger.  The  Sales  Ledger  controlling  ac- 
count will  also  be  debited  for  all  sums  posted  to  the  debit  of  the 
individual  accounts  in  the  sales  ledger  and  will  be  credited  for 
all  sums  posted  to  the  credit  of  the  customers'  accounts  in  the 
sales  ledger.  However,  the  controlling  account  is  a  summary 
account  and  usually  the  posting  to  this  account  is  done  at  the 
end  of  each  month,  only  the  totals  being  posted  from  each  book 
of  original  entry.  For  instance,  special  columns  may  be  provided 
in  the  journal,  cash  book,  sales  returns  book  and  notes  receivable 
book,  and  the  totals  of  these  columns  may  be  posted  at  the  end 
of  the  month.  Where  no  special  columns  are  provided,  then  the 
individual  items  will  be  posted.  After  all  posting  has  been  done 
the  Sales  Ledger  account  will  show  the  total  amount  due  from 
customers.  This  can  be  verified  by  preparing  a  schedule  of  the 
balances  of  the  accounts  with  customers  from  the  sales  ledger. 

Discounts.  In  the  treatment  of  the  accounts  with  custo- 
mers, the  subject  of  trade  and  cash  discounts  will  come  up. 
There  has  been  considerable  discussion  by  accountants  with 
regard  to  the  proper  treatment  of  discounts.  It  is  not  considered 
good  policy  to  permit  trade  discounts  to  appear  in  the  ledger 
at  all.  In  billing  customers,  trade  discounts  should  be  deducted 
from  the  invoices  before  they  are  mailed  out.  Likewise,  before 
invoices  are  entered  in  the  purchases  record,  all  trade  discounts 
should  be  deducted. 

A  trade  discount  is  usually  a  deduction  from  the  list  price 
regardless  of  the  time  of  payment.  Even  though  the  terms 
of  the  invoice  indicated  that  the  discount  would  not  be  allowed 


ACCOUNTS  RECEIVABLE  83 

after  thirty  days,  if  the  rate  were  greater  than  2%,  it  would 
seem  to  be  a  trade  discount,  for  it  is  apparent  that  anyone 
would  most  certainly  take  advantage  of  any  such  discount  even 
if  it  were  necessary  to  borrow  the  money  at  the  bank  paying 
6%  interest.  It  certainly  would  be  better  policy  to  pay  6% 
annual  interest  on  borrowed  money  than  to  lose  2%  discount 
per  month  on  purchases. 

Mr.  Montgomery,  says: 

"The  distinction,  therefore,  is  based  on  the  answer 
to  the  query:  Is  the  rate  one  which  is  obviously  granted 
for  anticipation  of  obligations  not  due?    For  instance, 
the  strict  enforcement  of  the  terms  '2  per  cent  ten 
days,  net  thirty  days'  indicates  that  the  2  per  cent  is 
an  earning  and  not  a  deduction  from  the  purchase  price. 
As  a  general  rule  any  discount  in  excess  of  the  terms 
just  mentioned  may  be  treated  as  a  trade  discount." 
Many  accountants  consider  a  discount  greater  than  one  per 
cent  as  a  trade  discount  and  it  will  be  noted  under  the  discussion 
of  "Auditing  Theory"  on  page  84  of  this  chapter,  that  the  Federal 
Reserve  Board  advocates  that  any  discount  exceeding  one  per 
cent  is  to  be  treated  as  a  trade  discount,  and  if  it  has  not  been 
deducted  from  the  invoices  before  recording  them  in  the  purchases 
book,  there  should  be  a  reserve  therefor  set  up  in  the  Balance 
Sheet. 

Doubtful  Accounts.  As  soon  as  an  account  is  known  to 
be  worthless  it  should  be  written  off  entirely;  however,  it  fre- 
quently happens  that  an  account  will  be  past  due  at  the  end  of 
a  fiscal  period,  yet  it  is  still  considered  good  and  it  may  not  be 
wise  to  write  it  off  as  a  loss.  Some  firms  keep  a  doubtful 
accounts  ledger,  and  when  an  account  is  past  due  and 
considered  at  all  doubtful,  it  is  written  off  the  regular  sales 
ledger  and  transferred  to  the  doubtful  accounts  ledger.  At  the 
same  time,  a  reserve  is  set  up  charging  the  current  period  with 
the  estimated  loss  on  such  accounts.  Other  firms  simply  leave 
all  accounts  stand  open  in  the  sales  ledger  until  they  are  either 
collected  or  are  found  to  be  absolutely  worthless,  and  set  up  a 
reserve  at  the  end  of  the  fiscal  period  for  an  amount  estimated 
to  be  sufficient  to  cover  the  loss.  The  Treasury  Department 
will  only  allow  as  a  deduction  from  income  the  actual  amount  of 
bad  debts  written  off,  but  this  doesn't  mean  that  all  doubtful 
accounts  should  be  written  off  before  determing  to  a  certainty 
that  they  are  uncollectible.  Returns  are  always  subject  to  in- 
spection by  Income  Tax  collectors  or  inspectors,  and  if  accounts 
considered  good  by  the  inspector  have  been  charged  off  they  most 
certainly  would  not  be  allowed.  Furthermore,  any  accounts 
written  off  and  subsequently  collected  would  be  taxable  as 
income  in  a  later  period.  Of  course,  it  frequently  happens  that 
an  account  considered  worthless  is  later  collected  in  full  or  in 
part.  This  should  be  considered  as  a  special  income. 


84  PUBLIC  ACCOUNTING  AND  AUDITING 

2.     AUDITING  THEORY 

Quoting  from  the  Federal  Reserve  Bulletin: 

Aging  Accounts.  "The  bookkeepers  of  the  accounts  re- 
ceivable ledgers  should  be  asked  to  draw  off  lists  of  the  open 
balances  at  the  end  of  the  fiscal  period,  and  distributions  of  the 
total  columns  should  be  shown  on  the  lists  according  to  the  age 
of  the  accounts,  e.  g.,  not  yet  due,  less  than  30  days  past  due, 
more  than  30  days  past  due.  (This  is  known  as  aging  accounts 
receivable).  The  accounts  paid  since  the  close  of  the  fiscal 
period  should  be  noted  in  the  lists  before  taking  up  the  matter  of 
past-due  accounts  with  the  credit  department,  as  payment  is 
the  best  proof  that  an  account  was  good  at  the  date  of  the  audit. 

Schedules  Agree  With  Controlling  Accounts.  "The 
totals  of  the  lists  of  outstanding  accounts  should  agree 
with  the  controlling  account  in  the  general  ledger  if  separate 
ledgers  are  kept.  When  credit  balances  appear  on  customers' 
accounts  they  should  be  shown  on  the  Balance  Sheet  as  a  separate 
item  and  not  deducted  from  the  total  of  debit  balances;  and  debit 
balances  on  the  accounts  payable  ledgers  should  be  treated  in 
the  same  manner. 

Lists  Verified.  "The  lists  must  be  footed  and  compared  in 
detail  with  the  customers'  accounts  in  the  ledgers. 

Accounts  Past  Due.  "The  composition  of  outstanding 
balances  should  be  examined,  as  it  frequently  happens  that  while 
a  customer  may  be  making  regular  payments  on  his  account, 
old  items  are  being  carried  forward  which  have  been  in  dispute 
for  a  considerable  period  of  time.  Such  items  and  accounts 
which  are  past  due  should  be  taken  up  with  the  credit  depart- 
ment or  some  responsible  officer,  and  the  correspondence  with 
the  customers  examined,  so  that  the  auditor  may  form  an  opin- 
ion of  the  worth  of  the  accounts  and  satisfy  himself  that  the  re- 
serve for  doubtful  accounts  set  up  by  the  company  is  sufficient. 

Discounts.  "Trade  discounts  (and  also  so-called  cash 
discounts,  if  exceeding  I  per  cent)  and  freights  allowed  by  the 
company  should  be  inquired  into,  and  if  they  have  been  included 
in  the  accounts  receivable,  a  reserve  therefor  should  be  set  up 
in  the  Balance  Sheet.  Also  inquiries  should  be  made  regard- 
ing customers'  claims  for  reductions  in  prices  and  for  rebates 
and  allowances  on  account  of  defective  materials,  so  that  it  may 
be  seen  that  a  sufficient  reserve  has  been  established  therefor. 

Accounts  Assigned,  Bad  Debts,  Deposits,  etc.  "Inquiry 
must  be  made  as  to  whether  any  of  the  accounts  receivable  have 
been  hypothecated  or  assigned,  and  the  sum  total  of  accounts  so 
listed  entered  under  2ob.  (See  page  41,  Chapter  Three.) 

"The  auditor  should  satisfy  himself  that  the  bad  debts 
written  off  have  been  duly  authorized  by  responsible  officials. 

"Accounts  due  from  directors,  officers,  and  employees  must 
be  stated  in  the  Balance  Sheet  separately  and  not  included  as 
trade  accounts.  This  applies  also  to  deposits  as  security,  guar- 
anties, and  other  extraordinary  items  not  connected  with  sales. 


ACCOUNTS  RECEIVABLE  85 

"Accounts  due  from  affiliated  concerns  must  not  be  included 
as  customers'  accounts,  even  though  arising  as  a  result  of  trading 
transactions.  Affiliated  companies'  accounts  should  be  shown  as 
a  separate  item  of  'current  assets'  or  as  'other  assets',  as  the 
circumstances  warrant.  They  may  be  fairly  included  as  'current 
assets'  if  the  debtor  company  has  ample  margin  of  quick  assets 
over  its  liabilities,  including  such  accounts. 

Verification  of  Accounts.  "Optional. — The  best  veri- 
fication of  an  open  balance  is  a  confirmation  by  the  customer; 
therefore,  if  time  permits  and  the  client  does  not  object,  it  is 
advisable  to  circularize  the  customers.  The  auditor  should  per- 
sonally see  the  circulars  mailed  after  comparing  them  wTith  the 
lists  of  outstanding  accounts.  The  envelopes  for  replies  sent 
with  the  circulars  should  be  addressed  direct  to  the  auditor. 

"In  large  concerns  the  system  of  accounting  is  generally 
so  arranged  that  it  would  be  almost  impossible  for  accounts 
to  be  paid  and  not  correctly  credited  on  the  accounts  receivable 
ledgers,  but  in  small  concerns,  with  imperfect  systems,  such 
occurrences  are  quite  possible,  so  much  so,  in  fact,  that  it  is 
generally  admitted  that  the  risk  of  errors  and  omissions  decreases 
in  direct  proportion  to  an  increase  in  bookkeeping." 

3.     AUDITING  PROCEDURE 

Space  will  not  permit  a  detailed  record  of  the  auditor's 
work  in  connection  writh  the  verification  of  accounts  receivable, 
therefore,  we  shall  limit  our  discussion  to  an  outline  showing 
the  procedure  of  the  audit. 

(i.)  A  transcript  of  the  Sales  Ledger  controlling  account 
in  the  general  ledger  was  made  showing  a  balance  of  $81,687.00. 

(2.)  The  schedule  of  accounts  receivable  furnished  the 
senior  by  Mr.  Pond,  the  chief  accountant,  was  checked  with 
the  sales  ledger  and  it  was  found  that  the  total  of  all  the  accounts 
with  debit  balances  amounted  to  $84,721.50,  while  the  total  of 
those  accounts  which  had  credit  balances  amounted  to  $3,034.50. 

(3.)  Terms  on  which  goods  are  sold,  net  30  days,  no  cash 
discount  allowed.  Trade  discounts  are  all  deducted  from  the 
invoices  and  no  accounts  with  these  discounts  is  maintained  in 
the  ledger. 

(4.)  The  junior  next  divided  the  accounts  receivable  into 
three  lists:  Those  not  yet  due;  those  less  than  30  days  past 
due;  and  those  more  than  30  days  past  due.  The  results  showed 
accounts  amounting  to  $73,807.80  were  not  yet  due,  accounts 
amounting  to  $8,755.70  were  less  than  30  days  past  due,  and 
accounts  amounting  to  $2,158.00  were  more  than  30  days  past 
due.  After  this  was  completed  those  accounts  more  than  30  days 
past  due  were  taken  up  with  the  credit  man  and  carefully  analyzed. 

(5.)  It  was  ascertained  that  at  the  beginning  of  the  year, 
January  I,  1918,  the  total  of  accounts  receivable  amounted  to 
$51,200.00.  A  reserve  for  bad  debts  amounting  to  2%  was  set 
up  at  that  time.  During  the  year  accounts  amounting  to  $970.00 


86  PUBLIC  ACCOUNTING  AND  AUDITING 

were  found  to  be  worthless  and  were  charged  off  by  debiting 
the  reserve  account.  These  were  found  to  have  been  duly 
authorized.  Conversation  wTith  the  credit  man  revealed  the 
fact  that  the  experience  of  the  Company  during  the  past  five 
years  indicated  that  their  annual  losses  from  bad  debts  amounted 
to  approximately  2%  of  the  total  accounts  receivable. 

(6.)  No  accounts  were  found  to  be  hypothecated  or  as- 
signed. 

(7.)  No  accounts  from  directors,  officers  or  employees  were 
found  to  be  included  in  the  accounts  receivable;  also  that  there 
were  no  deposits,  guarantees,  or  any  extraordinary  items  in- 
cluded. The  credit  balances  noted  in  connection  with  a  few 
of  the  customers'  accounts  were  found  to  represent  overpay- 
ments, allowances  on  merchandise  returned  and  other  allowances 
on  account  of  just  claims. 

(8.)  With  the  consent  of  the  client,  statements  were  made 
out  and  mailed  to  all  customers.  By  means  of  a  rubber  stamp 
the  following  notice  appeared  on  each  statement: 


Please  examine  this  account  immediately.  If 
incorrect,  address  J.  F.  Sherwood,  Certified  Public 
Accountant  and  Auditor,  309  West  Third  St.,  Cin- 
cinnati, Ohio. 


4.     INCOME  TAX  PROCEDURE 

Reserve  for  Bad  Debts  not  a  Deduction  from  Income. 

In  preparing  Income  Tax  returns  the  amount  set  up  as  a  reserve 
for  bad  debts  is  not  a  deduction  from  income,  only  the  specific 
debts  actually  charged  off  during  the  year  may  be  deducted. 

Income  Tax  Law.  Section  214.  (a)  [Individ- 
uals], "That  in  computing  net  income  there  shall  be 
allowed  as  deductions: 

(7.)  "Debts  ascertained  to  be  worthless  and 
charged  off  within  the  taxable  year." 

Section  234.  (a)  [Corporations]  "That  in  com- 
puting the  net  income  of  a  corporation  subject  to  the  tax 
imposed  by  Section  230,  there  shall  be  allowed  as  de- 
ductions : 

(5).     "Debts  ascertained  to  be  worthless  and  charged 
off  within  the  taxable  year." 

(*T.  D.  2433,  January  8,  1917)  "Reserves  to  meet  losses 
contingent  upon  shrinkage  in  values,  losses  from  bad  debts, 
capital  investments,  etc.,  are  deductible  only  when  definitely 
determined  as  the  result  of  a  closed  or  completed  transaction 
and  are  charged  off." 

Tax  Decision. 


ACCOUNTS  RECEIVABLE  87 

There  has  been  great  dissatisfaction  over  this  phase  of  the 
Income  Tax  Law  for  in  most  cases  the  only  difference  between 
the  net  profit  shown  on  the  books  of  account  and  the  Income 
Tax  returns  has  been  the  item  of  bad  debts.  Some  bookkeepers 
and  business  men  have  conceived  the  idea  that  it  is  not  permis- 
sible to  set  up  a  reserve  for  bad  debts  under  the  Income  Tax  Law. 
This  is  incorrect;  in  fact,  the  failure  to  set  up  reserves  is  opposed 
to  correct  accounting  and  if  reflected  in  a  Balance  Sheet  in  some 
states  will  subject  the  person  who  signs  it  to  severe  penalties, 
including  imprisonment  for  obtaining  credit  upon  a  false  finan- 
cial statement.  However,  under  the  Treasury  regulations,  the 
Income  Tax  returns  must  ignore  the  results  shown  in  the  books 
of  account.  One  can  claim  as  deductions  only  debts  charged 
off  within  the  year  and  must  not  use  the  amount  set  up  as  a 
reserve  for  debts  not  yet  charged  off.  In  order  to  comply  with 
existing  regulations,  taxpayers  should  be  careful  to  include  in 
their  returns  all  accounts  charged  off  as  bad  during  the  year, 
whether  debited  in  the  books  to  reserve  accounts,  to  Bad  Debts 
account,  or  to  the  Profit  and  Loss  account. 

Definition  of  a  Bad  Debt.     (Regulation  No.  33,  1918, 

H95-)  "A  bad  debt  or  worthless  debt,  as  contemplated  by  the 
Income  Tax  Law  and  which  may  be  deducted  in  a  return  of 
income,  is  a  debt  which  has  been  actually  ascertained  to  be 
worthless  and  charged  off  within  the  taxable  year." 

(Reg.  No.  1918,  H94.)  "Where  all  of  the  surrounding  and 
attendant  circumstances  indicate  that  a  debt  is  worthless  and 
uncollectible  and  that  legal  action  to  enforce  payment  would  in 
all  probability  not  result  in  the  satisfaction  of  execution  on  a  judg- 
ment, a  showing  of  these  facts  will  be  sufficient  showing  of  the 
worthlessness  of  the  debt  for  purposes  of  deduction." 

Bad  Debts  Charged  oil  and  Later  Collected  Must  Be 
Considered  Income.  (Reg.  No.  33,  1918,  ^[14.)  [Indivi- 
duals] "Bad  debts  which  have  been  claimed  and  allowed  as  a 
deduction  in  prior  returns  are  considered  income  if  subsequently 
collected." 

(Reg.  No.  33,  1918,  ^380.)  [Corporations]  "Bad  debts  or 
accounts  charged  off  by  a  corporation  because  of  the  fact  that 
they  were  determined  to  be  worthless,  and  subsequently  re- 
covered, constitute  income  for  the  year  in  which  recovered, 
regardless  of  the  date  when  the  amounts  were  charged  off. 
Neither  the  date  at  which  the  debt  was  charged  off  nor  the 
fact  that  it  was  or  was  not  deducted  from  gross  income  in 
any  return  made  for  tax  purposes  will  in  any  way  affect  its 
character  as  income  of  the  year  in  which  recovered." 

Income  Corresponding  To  Bad  Debt  Must  Have  Been 
Represented  in  Tax  Returns  In  Order  To  Be  Deductible. 

(Reg.  No.  33,  1918,  ^[96.)  "Debts  arising  from  unpaid  wages, 
salaries,  rents  and  items  of  similar  taxable  income  will  not  be 
allowed  as  a  deduction  unless  the  income  they  represent  has  been 


88  PUBLIC  ACCOUNTING  AND  AUDITING 

included  in  the  return  of  gross  income  for  the  year  in  which 
the  deduction  as  a  bad  debt  is  sought  to  be  made  or  in  a  previous 
year  and  the  debts  themselves  have  been  actually  ascertained 
to  be  worthless  and  charged  off." 

The  following  questions  and  answers  taken  from  the 
Income  Tax  Primer,  1918,  will  furnish  additional  infor- 
mation: 

(Question  94.)  "If,  on  account  of  friendship  or  relationship 
I  advanced  a  certain  sum  to  assist  a  needy  friend  or  relative, 
and  at  the  time  such  advance  was  made  I  had  little  or  no  reason 
to  expect  that  the  amount  so  advanced  would  ever  be  returned, 
may  I  now  claim  a  deduction  to  cover  such  advance? 

"No.  Such  an  advance,  partaking,  as  it  does,  somewhat 
of  the  nature  of  a  philanthropic  donation  or  a  good  will  offering, 
is  not  held  to  constitute  a  bona  fide  debt." 

(Question  96.)  "A  professional  man  earned  a  fee  in  1916. 
As  he  keeps  no  books,  he  reports  his  income  for  tax  purposes 
on  an  actual  receipt  basis.  As  this  fee  has  never  been  reported 
as  income,  can  it  be  claimed  as  a  deduction  if  collection  can  not 
be  made? 

"No;  never  having  been  returned  as  income  it  cannot  be 
claimed  as  a  deduction." 

(Question  91.)  "In  1917  a  corporation  or  a  firm  to  which  I 
had  loaned  money  became  bankrupt.  Can  this  debt  be  con- 
sidered absolutely  worthless  and  claimed  as  a  deduction  for 
1917? 

"No,  unless  the  affairs  of  the  debtor  have  been  finally 
adjusted,  its  assets  sold  for  the  benefit  of,  or  distributed  to,  its 
creditors,  and  its  receiver  in  bankruptcy  discharged.  If  all  this 
has  occurred  during  the  year  1917,  so  much  of  the  debt  as 
remains  unpaid  after  the  receiver  is  discharged  may  be  claimed 
as  a  deduction  for  the  year  1917." 

(Question  92).  "Is  it  absolutely  necessary  that  the  debtor 
corporation  or  firm  mentioned  in  the  ninety-first  inquiry  be 
declared  a  bankrupt  and  its  receiver  discharged  before  I  can 
claim  a  deduction  on  account  of  the  debt  in  question? 

"No.  If  the  debtor  corporation  has  no  assets  whatsoever, 
and  it  is  definitely  known  that  nothing  whatsoever  can  be  col- 
lected from  debtor  itself  or  any  person  connected  with  it, 
a  creditor  need  not  go  to  the  expense  of  instituting  bankruptcy 
proceedings  in  order  to  establish  his  right  to  claim  the  worthless 
debt  as  a  deduction." 

5.     LEGAL  PHASES 

An  Account  Stated.  This  is  defined  in  Webster's  Dic- 
tionary as  "an  account  presented  and  accepted  by  both  parties." 

Therefore,  it  would  seem  to  mean  an  account  rendered  and 
agreed  to  by  both  the  buyer  and  seller,  consequently  in  a  suit 


ACCOUNTS  RECEIVABLE  89 

for  collection,  it  would  not  be  neccessary  to  prove  the  items 
composing  the  account,  because  each  of  the  parties  concerned 
had  previously  agreed  to  them  as  stated  in  the  account. 

Proceedings  for  the  Collection  of  an  Unsecured  Debt. 

When  a  debt  is  unsecured,  it  is  first  necessary  to  bring  suit  and 
to  secure  a  judgment  against  the  debtor  before  the  court  will 
grant  an  execution.  An  execution  takes  the  form  of  an  attach- 
ment and  a  sale  by  the  sheriff  of  the  debtor's  property  after 
being  advertised  in  the  manner  required  by  law.  There  are 
certain  exemptions  that  apply  and  these  are  definitely  enum- 
erated by  the  statutes  covering  the  matter  in  the  various  states. 
An  execution  can  only  be  enforced  against  property  within  the 
jurisdiction  of  the  court  granting  it,  and  if  there  is  property 
belonging  to  the  debtor  not  in  the  jurisdiction,  it  would  be  neces- 
sary to  file  a  transcript  of  the  judgment  and  secure  another 
execution.  It  may  be  necessary  to  obtain  a  new  judgment 
for  property  outside  of  the  state. 

An  Account  "Outlawed.'*  The  Statue  of  Limitations 
applies  to  open  accounts  as  well  as  to  notes  and  judgments.  An 
open  account  is  said  to  be  "outlawed"  if  not  collected  within  the 
time  limit  set  by  law.  This  varies  in  the  different  states  from 
two  to  eight  years.  However,  if  a  part  payment  is  made  on  an 
account,  then  the  time  limit  is  automatically  extended  from 
that  date.  The  limit  on  a  judgment  is  much  longer  than  on  an 
open  account  and  varies  from  five  to  twenty  years.  An  auditor 
in  verifying  accounts  receivable  should  always  be  on  the  look- 
out for  accounts  long  past  due.  These  accounts  if  more  than 
two  years  old  might  be  uncollectible.  The  same  is  true  with 
regard  to  a  judgment.  It  would  be  well  for  the  student  to  obtain 
a  copy  of  the  Statute  of  Limitations  of  his  state. 

Applying  Part  Payments  on  an  Account.  A  debtor  has 
the  right  by  law  to  indicate  on  what  item  his  payment  shall  be 
applied.  Hence,  if  he  owes  several  amounts  and  wishes  the  pay- 
ment to  be  applied  on  any  one  particular  amount  and  requests 
it,  the  credit  must  be  applied  on  that  amount. 

A  partial  payment  made  on  a  debt  bearing  interest  is  first 
applied  in  payment  of  interest,  and  if  more  than  sufficient,  the 
remainder  is  applied  in  payment  of  the  principal. 

Payment  at  Maturity.  Payment  of  a  debt  must  be 
made  on  the  day  it  falls  due,  unless  it  be  a  holiday,  in  which 
case  it  must  be  made  the  next  secular  or  business  day.  If  a 
debt  is  not  paid  when  it  becomes  due,  it  must  bear  interest 
from  that  date  until  paid.  Payment  must  be  made  to  the 
creditor  personally,  or  his  duly  authorized  agent,  at  the  creditor's 
office,  residence  or  wherever  he  may  be,  the  debtor  being  re- 
quired to  find  his  creditor  and  not  the  creditor  to  seek  his  debtor. 


90  PUBLIC  ACCOUNTING  AND  AUDITING 

Receipt — A  Matter  of  Courtesy.  A  debtor  cannot  in- 
sist upon  a  receipt  as  a  condition  precedent  to  payment  of  a 
debt  when  it  is  his  duty  to  pay.  A  debtor  is  not  legally  entitled 
to  a  receipt  except  as  follows: 

1.  In  some  instances  the  statute  makes  it  the  duty  of  a 
public  officer  to  give  a  receipt  for  money  paid  to  him  in  his 
official  capacity. 

2.  In  a  number  of  the  states  it  is  provided  by  statute 
that  a  person  making  a  tender  may  demand  a  receipt  in  writ- 
ing, duly  signed,  as  a  condition  precedent  to  delivery. 

The  Sales  Contract.  There  is  a  difference  between 
"sales"  and  "contracts  to  sell."  The  following  definitions  are 
taken  from  the  Uniform  Sales  Act:* 

"A  sale  of  goods  is  an  agreement  whereby  the  seller  trans- 
fers the  property  in  goods  to  the  buyer  for  a  consideration  called 
the  price." 

"A  contract  to  sell  goods  is  a  contract  whereby  the  seller 
agrees  to  transfer  the  property  in  goods  to  the  buyer  for  a  con- 
sideration called  the  price." 

An  actual  sale  is  sometimes  called  an  "executed  contract 
sale,"  whereas  a  contract  to  sell  is  called  an  "executory  con- 
tract of  sale." 

Essentials  of  a  Valid  Sale.  All  the  usual  essentials  of 
an  ordinary  contract  apply  to  sales. 

1.  Competent  parties.     Both  the  seller  and  buyer,  legally 
known  as  the  vendor  and  vendee,  must  be  competent  to  contract. 

2.  Mutual  assent.    There  must  be  an  agreement  between 
the  parties  that  the  title  to  the  thing  sold  is  to  be  transferred 
to  the  buyer. 


*The  Uniform  Sales  Act  was  prepared  by  a  commission  on  Uniform 
State  Laws.  The  commission  was  appointed  by  the  various  states  to  unite 
in  working  out  uniform  laws  governing  sales.  As  a  result  of  the  work  of  this 
committee,  we  have  three  different  acts  relating  to  sales  and  allied  subjects: 

(a)  The  Uniform  Sales  Act. 

(b)  The  Uniform  Warehouse  Receipts  Act. 

(c)  The  Uniform  Bills  of  Lading  Act. 

The  Uniform  Sales  Act  has  now  been  adopted  in  the  following  states: 

Arizona  Minnesota  Oregon 

Connecticut  Mississippi  Pennsylvania 

Idaho  Missouri  Rhode  Island 

Illinois  Nevada  Tennessee 

Iowa  New  Jersey  Utah 

Maryland  New  York  Wisconsin 

Massachusetts  North  Dakota  Wyoming 

Michigan  Ohio  Alaska  (Terr.) 


THE  UNIFORM  SALES  ACT  91 

3.  Legal  Subject  Matter.     The  seller  must  possess  owner- 
ship of  the  title  of  the  goods  in  order  to  be  able  to  convey  title 
to  the  buyer.    One  who  sells  property  to  which  he  has  no  title 
such  as  lost,  stolen  or  borrowed  goods,  passes  no  right  of  posses- 
sion to  an  innocent  buyer.    The  seller  cannot  transfer  the  owner- 
ship of  something  which  is  not  in  existence,  or  of  something 
which  he  does  not  own.     He  can,  however,  enter  into  an  execu- 
tory contract  of  sale  whereby  he  may  agree  to  sell  goods  to  be 
manufactured,  altered,  delivered,  etc.,  before   actually  passing 
the  title  to  the  buyer. 

4.  Consideration.     There  can  be  no  sale  without  a  price. 
It  is  this  element  that  distinguishes  a  sale  from  a  gift  or  a  barter. 
When  property  is  transferred  by  gift,  title  is  passed  as  soon 
as  it  is  delivered  to  the  recipient  and  cannot  be  recovered  by 
the  giver.     A  barter  is  a  trade  whereby  goods  are  exchanged 
for  other  goods  instead  of  for  money. 

A  contract  of  sale  is  valid,  however,  even  though  no  price 
is  mentioned,  because  the  court  will  assume  that  the  goods  are 
to  be  paid  for  at  a  reasonable  price  and  the  buyer  will  be  charged 
accordingly.  If  goods  are  ordered  and  it  is  agreed  that  the  price 
is  to  be  fixed  at  a  later  date,  there  is  neither  a  sale  nor  a  contract 
to  sell  because  one  of  the  essentials  of  the  contract  has  been 
omitted.  However,  there  may  be  provisions  in  the  contract 
to  the  effect  that  the  price  is  made  dependent  on  outside  cir- 
cumstances. For  instance,  the  price  may  be  the  market 
price  on  the  day  of  delivery,  or  it  may  be  agreed  that  the  price 
is  to  be  fixed  by  a  third  party.  The  fact  that  the  price  may 
be  inadequate  or  excessive  does  not  invalidate  a  sale  or  a  con- 
tract to  sell.  If  the  parties  to  a  contract  are  competent  and 
yet  one  of  them  enters  into  a  poor  bargain,  the  court  will 
not  extend  relief  or  sympathy. 

5.  Contracts   to  sell   must  comply  with   the  Statute  of 
Frauds.     The  Statute  of  Frauds  applies  to  contracts  to  sell 
where  delivery  is  to  be  made  later  and  where  the  value  is  over 
a  certain  amount.     This  amount  varies  in  the  different  states, 
ranging  from  $30.00  in  Arkansas,  Maine  and  Missouri  to  $500.00 
in   Arizona,    Massachusetts,    New   Jersey   and    Rhode    Island, 
and  up  to  $2,500.00  in  Ohio,  but  $50.00  is  the  usual  sum. 

Where  the  Uniform  Sales  Act  has  been  passed,  the  value  of 
the  goods  is  the  basis,  but  in  many  states  the  statutes  specify 
that  the  price  is  the  basis.  Where  the  amount  is  based  on  the 
price  then  it  may  be  fixed  by  the  parties  themselves,  but  when 
it  is  based  on  the  value  then  the  actual  market  value  is  used. 
Therefore,  any  contract  to  sell  goods,  amounting  in  value  to 
more  than  the  specified  sum  in  that  state,  to  be  enforceable, 
must  be  supported  by  a  written  memorandum  of  the  terms  of 
the  agreement  signed  by  the  party  against  whom  it  is  sought 
to  force  the  contract  or  his  agent.  This  memorandum  need  not 


92  PUBLIC  ACCOUNTING  AND  AUDITING 

be  formal ;  it  may  be  merely  a  note,  a  letter,  a  telegram,  a  receipt 
or  miscellaneous  papers  connected  in  some  way  so  as  to  make 
an  intelligent  contract. 

There  are  two  exceptions  to  the  above:  First,  in  case  the 
buyer  has  paid  part  of  the  purchase  price;  second,  in  case  the 
buyer  has  accepted  and  actually  received  part  of  the  goods. 
Hence,  a  part  payment  will  bind  a  bargain  to  sell  goods,  but 
it  is  a  poor  substitute  for  a  written  contract.  Likewise,  if  a 
purchaser  has  accepted  all  or  part  of  the  goods  the  contract 
will  be  binding,  but  at  the  same  time,  the  purchaser  might  still 
dispute  the  prices,  warranties  and  other  terms  of  the  agreement. 
WRITTEN  CONTRACTS  ARE  THE  ONLY  DEPENDABLE 
MEANS  FOR  PROVING  AGREEMENTS. 

Warranties.  A  warranty  is  defined  in  Webster's  diction- 
ary as  "an  assurance  or  undertaking  by  the  seller  of  property, 
expressed  or  implied,  that  the  property  is  or  shall  be  as  it  is 
represented,  or  promised  to  be  as  to  quantity,  quality  or  title." 

An  expressed  warranty  is  a  statement  made  by  the  seller 
concerning  the  quality,  durability,  working  ability,  etc.,  of  the 
article  sold  in  order  to  induce  the  buyer  to  purchase.  In  the 
case  of  a  sale  the  warranty  may  be  either  oral  or  written,  but 
in  the  case  of  a  contract  to  sell  goods  over  a  certain  sum  in 
value,  then  it  should  be  in  writing.  These  statements  must  be 
definite  and  not  qualified.  It  is  often  difficult  to  determine  the 
difference  between  statements  of  fact  and  expressions  of  opinion. 
The  buyer  must  be  on  the  lookout  to  detect  mere  expressions 
of  opinion.  "Get-rich-quick"  schemes  are  unloaded  on  an  un- 
suspecting public  because  they  do  not  note  the  difference  be- 
tween a  statement  of  fact  and  misrepresentation  or  an  expres- 
sion of  opinion. 

In  every  sale  there  are  certain  implied  warranties.  The 
seller  warrants  by  the  mere  act  of  selling  goods  (a)  that  he  has 
the  right  to  sell,  or  in  the  case  of  a  contract  sale  that  he  will 
have  the  right  to  sell  when  the  time  for  the  sale  arrives ;  (b)  that 
the  buyer  shall  not  be  disturbed  by  claims  made  by  others 
against  the  goods  he  has  purchased;  (c)  that  the  goods  are  free 
from  claims,  charges  or  incumbrances  at  the  time  of  sale. 

Remedies.  The  seller  has  certain  defined  remedies  for 
wrongful  acts  of  the  buyer.  The  buyer  also  has  certain  remedies 
in  case  of  breach  of  contract  or  breach  of  warranty  by  the  seller. 

Under  certain  conditions  the  seller  may  recover  the  sale 
price  and  under  other  conditions  he  may  recover  damages.  If 
the  seller  contracts  to  sell  and  tenders  the  goods  covered  by  the 
contract  and  the  buyer  refuses  to  receive  the  goods  without  just 
cause,  he  may  recover  the  sale  price,  or  he  may  elect  to  retain 
the  goods  and  recover  damages.  Usually  the  amount  of  damages 


ACCOUNTING  PROBLEMS  93 

will  be  the  difference  between  the  market  price  of  the  goods 
and  the  contract  price. 

There  are  so  many  exceptions  to  the  general  rules  concerning 
contracts  to  sell  and  sales  that  all  can  not  be  enumerated  here. 
In  actual  practice,  specific  cases  involving  a  knowledge  of  the 
statutes  will  often  occur,  but  the  accountant  or  auditor  will 
always  be  able  to  look  up  the  statutes  in  question  before  making 
decisions. 

Auction  Sales.  Auction  sales  are  made  in  accordance 
with  the  terms  printed  on  the  hand  bills  advertising  it.  Deposits 
may  be  required  before  one  is  entitled  to  bid,  or  deposits  may 
be  required  after  the  bid  is  made.  All  bids  below  a  certain  sum 
may  be  refused,  but  it  is  customary  to  sell  to  the  highest  bidder. 
Before  bidding  on  goods  offered  at  auction  sale,  one  should 
acquaint  himself  with  the  terms  of  sale. 


A.    THEORY  QUESTIONS 

1.  Explain  in  full  your  method  of  arriving  at  a  correct 
allowance  for  bad  debts.  C.  P.  A.  Mich. 

2.  Differentiate  between  the  following  discounts,  viz:    2% 
IO  days,  30  days  net;    and  5%  on  settlement.       C.  P.  A.  Ind. 

3.  A  corporation  has  a  controlling  account  in  the  general 
ledger  for  accounts  receivable.     The  balance  of  the  controlling 
account  is  $80,000.    The  debit  balances  of  the  individual  accounts 
total  $100,000,  and  the  credit  balances  total  $20,000.    Is  a  state- 
ment correct  which  uses  the  controlling  account  balance  as  an 
asset?  If  not,  what  would  you  do?    Give  reasons.    C.  P.  A.  Mich. 

4.  Mention   three  classes  of  transactions  which  a  debit 
item  may  represent  in  a  customer's  account. 

Inst.  Ex.  1918. 

5.  Indicate  what  would  guide  you  in  examining  and  criticis- 
ing accounts  receivable  carried  on  the  branch  office  books  of  a 
business.    What  would  you  require  before 

(a)  accepting  the  debits  as  good  or 

(b)  writing  off  those  you  were  told  were  bad? 

Inst.  Ex.  1918. 

B.     ACCOUNTING  PROBLEMS 

I.     When  auditing  the  books  of  a  company  which  are  not 
in  balance,  the  following  errors  are  discovered: 

(i)  A  check  drawn  for  $110  is  entered  in  the  cash 
book  as  a  collection  of  $100  and  posted  to  the  debit  of  the 
creditor's  account  as  $110. 


94  PUBLIC  ACCOUNTING  AND  AUDITING 

(2)  A  customer's  credit  memo  of  $25  is  included  as 
a  sale  and  posted  to  the  credit  of  the  customer's  account 
as  $20. 

(3)  The  debit  side  of  the  cash  book  is  underfooted 
$100,  and  a  check  drawn  for  $100  in  payment  of  a  creditor's 
account  is  not  entered  in  the  cash  book. 

(4)  Discounts  received  of  $250  are  posted  as  discounts 
allowed. 

To  correct  the  foregoing  errors,  prepare  journal  entries 
for  accounts  in  the  general  ledger  and  subsidiary  ledgers  which 
are  controlled  by  accounts  in  the  general  ledger. 

C.  P.  A.  Kans.  and  Mo. 

.  (Note.  When  errors  are  found  in  an  audit  of  the  accounts,  adjusting 
entries  are  necessary.  These  are  usually  made  in  the  general  journal  and  posted 
to  the  accounts  affected.  The  first  item  is  not  quite  clear,  but  you  may 
assume  that  through  the  use  of  controlling  columns  the  following  entry  was 
made  in  the  cash  book: 

Cash $100.  oo 

Customer's  controlling  account $100.00 

The  above  entry  was  posted  as  a  debit  of  $110  to  the  correct  individual 
creditor's  account. 

The  other  items  should  be  easily  understood  and  there  should  be  no 
difficulty  experienced  in  framing  an  adjusting  entry  for  each.) 

2.  The  Trial  Balance  of  a  manufacturing  firm  taken 
January  i,  1897,  is  as  follows: 

Capital  A $40,000 

Capital  B 20,000 

Plant  and  Machinery $35,ooo 

Purchases 38,000 

Sales 95,ooo 

Stock  on  hand  January  i,  1896 15,000 

Labor 24,000 

Salaries 6,000 

Traveling  Expenses 2,500 

Interest 600 

Stationery  and  Printing 1,200 

Rents  and  Taxes 3>5°o 

Discounts  and  Allowances 1,250 

Fuel 3,ooo 

Insurance  (one  year  from  July  i ,  1 896)  i ,  1 50 

Freight 1 ,500 

General  Expenses 600 

Bank  Overdraft 5,ooo 

Creditors 4,000 

Accounts  Receivable 25,000 

Rent  of  Steam  Power 1,500 

Cash  on  hand 200 

Loan  Account 7,000 

$165,500         $165,500 


ACCOUNTING  PROBLEMS  95 

Stock  on  hand  January  I,  1897,  $23,000;  each  partner  to 
be  credited  6%  on  his  capital  for  one  year  before  profits  are 
ascertained;  3%  to  be  written  off  accounts  with  creditors  for 
discount;  10%  to  be  written  off  machinery  and  plant  for  depre- 
ciation; unexpired  insurance  to  be  taken  into  account;  net 
profit  to  be  divided  2-3  to  A  and  1-3  to  B.  Draft  adjusting 
and  closing  entries.  Prepare  final  Trial  Balance  and  a  Balance 
Sheet.  You  need  not  set  up  ledger  accounts  as  a  part  of  your 
solution.  C.  P.  A.  N.  Y. 

(Note.  Do  not  misinterpret  the  item  "3%  to  be  written  off  accounts 
with  creditors  for  discount."  It  appears  that  there  is  a  trade  discount  of  3% 
that  was  not  deducted  from  the  invoices  before  they  were  entered  on  the  books; 
therefore,  an  adjusting  entry  is  necessary.  The  following  entry  is  the  proper 
adjustment: 

Trade  Discounts $120.00 

Purchases $120.00 

To  write  off  a  trade  discount  of  3%  on  purchases,  same  not  having 

been  deducted  from  the  invoices  before  they  were  entered  on  the  books. 

The  amount  of  the  reserve  for  trade  discounts  should  be  deducted  from 
the  sum  of  accounts  payable  in  the  Balance  Sheet.) 

3.  The  following  figures  are  taken  from  the  books  of 
A.  B.  Mills  as  at  December  31,  1906.  You  are  requested  to 
prepare  from  them  a  Trial  Balance  and  a  Balance  Sheet.  The 
period  is  one  year. 

Yarn  (used) $25,000 

Sales 81,250 

Wages 22,500 

Discounts  Received 2,500 

Dyeing 12,500 

Power,  Light  and  Heat 3.125 

Boxes  and  Cases 1,250 

Repairs 685 

Sundry  Expenses  (Mills) 1,060 

Insurance 1 55 

Salaries 2,500 

Taxes 310 

Depreciation 425 

Advertising 1 ,250 

Traveling  Expenses 1,125 

Returns 1 ,000 

Commissions l|875 

Discounts  Allowed 440 

Interest  on  Loans 410 

Cash  at  Bank  and  on  hand 14,065 

Bills  Payable 37,5oo 

Sundry  Debtors 22,500 

Sundry  Creditors 6,250 

(Concluded  on  page  06) 


96  PUBLIC  ACCOUNTING  AND  AUDITING 

Fixtures,  Fittings,  Office 4r75O 

Capital 93.750 

Machinery  and  Plant 65,925 

Bills  Receivable 38,400 

(Note.    The   above  problem  is  taken  from   the  final  examination  of 
the  Society  of  Accountants  and  Auditors  in  London,  England,  June,  1907.) 


C.    LEGAL  QUESTIONS 

1.  (a)  What  does  a  seller  impliedly  warrant  in   the  sale 
of  a  chattel? 

(b)  State  all  the  legal  requisites  of  a  valid  sale. 

Inst.  Ex. 

2.  Define  a  sale.     What  is  the  difference  between  a  sale 
and  an  exchange  or  barter?  C.  P.  A.  Ind. 

3.  Can  a  merchant  sell  articles  that  he  is  to  manufacture 
next  season?  C.  P.  A.  Ind. 

4.  What  is  an  account  stated?  C.  P.  A.  Mich. 

5.  Answer  briefly : 

(a)  What  is  a  debt  and  what  can  a  creditor  demand 
in  payment  of  a  debt? 

(b)  When  a  creditor  accepts  in  satisfaction  payment 
of  less  than  the  full  amount  of  a  debt,  how  can  the  debtor  guard 
against  further  demands? 

(c)  When,  where  and  to  whom  must  payment  of  a 
debt  be  made? 

(d)  Is  the  debtor  legally  entitled  to  a  receipt? 

(e)  Which  has  the  prior  right  to  apply  a  payment 
against  any  one  of  several  debts,  the  debtor  or  the  creditor? 

(f)  When  a  partial  payment  is  made  on  a  debt  bear- 
ing interest,  in  what  manner  is  it  applied?  C.  P.  A.  N.  Y. 


Chapter  Seven 
INVENTORIES 

Reference  to  the  inventory  of  the  Blank  Manufacturing 
Company,  on  page  51  of  Chapter  Four,  will  show  that  the  inven- 
tory is  made  up  as  follows:  Finished  stock,  $80,000.00;  materials 
and  stock  in  process,  $55,000.00. 

1.    ACCOUNTING  THEORY 

Book  Inventories.  There  is  a  growing  tendency  on  the 
part  of  manufacturing  and  trading  concerns  to  keep  a  merchan- 
dise stock  ledger,  commonly  known  as  a  "running"  or  "going" 
inventory.  Every  business  firm  keeps  a  record  of  cash  regardless 
of  what  other  records  are  kept.  It  is  difficult  to  understand 
why  it  isn't  just  as  important  to  keep  an  accurate  record  of  mer- 
chandise as  it  is  of  cash.  Without  a  do"ubt,  the  loss  from  thefts  and 
misappropriation  of  merchandise  amounts  to  more  in  a  year  than 
embezzlements  of  cash  amount  to  in  a  decade.  It  is  a  well 
known  fact  that  merchandise,  worth  millions  of  dollars,  is  carried 
away  annually  by  employees  and  others  because  they  know  it 
will  never  be  discovered.  In  the  face  of  these  facts,  it  would 
seem  to  be  equally  important  to  keep  an  accurate  record  of 
all  merchandise,  whether  the  business  is  a  trading  or  a  manu- 
facturing concern. 

Without  the  waste  of  time,  labor  and  delay  incident  to 
stocktaking,  the  manufacturer  and  trader  should,  at  all  times, 
know  exactly  how  he  stands  concerning  the  amount  and  value 
at  cost  price  of  all  stock  on  hand,  whether  it  be  raw  material, 
goods  in  process  of  manufacture,  or  finished  goods. 

If  a  separate  merchandise  stock  ledger  is  kept,  then  it  will 
be  necessary  to  maintain  a  controlling  account  in  the  general 
ledger  the  same  as  for  any  other  subsidiary  ledger.  The  accounts 
in  the  merchandise  stock  ledger  will  usually  show  on  the  debit 
side  quantities  purchased,  cost  per  unit  and  amount;  on  the 
credit  side  quantities  sold,  cost  per  unit  and  cost  of  quantity 
sold.  A  balance  column  is  also  provided  so  that  there  is  shown 
quantities  on  hand,  cost  per  unit  and  total  amount  or  value  at 
cost  price.  Where  prices  are  subject  to  fluctuations  or  have  fluc- 
tuated considerably,  the  average  cost  and  amount  is  often  used. 
It  is  better,  however,  to  use  the  exact  cost  per  unit  and  exact 
amount  where  it  can  be  ascertained,  and  it  usually  can  be  as- 
certained. 

97 


98  PUBLIC  ACCOUNTING  AND  AUDITING 

Physical  Inventories.  Whether  or  not  a  book  inventory 
is  maintained,  it  is  important  that  at  least  once  a  year,  and 
oftener  in  some  cases,  a  physical  inventory  be  taken.  For  the 
same  reason  that  cash  is  counted  to  verify  the  cash  book  balance 
so  an  inventory  should  be  taken  to  verify  the  result  shown  by 
the  stock  records.  In  the  event  that  there  is  a  differentiation 
between  the  physical  and  book  inventories,  it  should  be  of  as 
great  concern  as  a  shortage  of  cash.  Isn't  it  a  fact  that  mer- 
chandise represents  money's  worth?  If  a  cashier  is  short  in  his 
cash,  he  must  pay  it  out  of  his  pocket  or  the  proprietor  must 
pay  it  out  of  his  capital.  Why  should  not  the  liability  of  either 
the  store-keeper  or  stock-keeper  be  regarded  in  the  same  light 
as  is  the  cashier  with  respect  to  responsibility? 

At  the  present  time  most  accounting  firms  agree  that  the 
inventory  should  be  taken  at  cost  price  or  market  price,  which- 
ever may  be  the  lower,  but  in  no  event  should  it  be  taken  at  a 
price  higher  than  the  actual  cost  price.  An  exception  to  this  general 
theory  is  the  following,  quoted  from  Paul  Joseph  Esquerre*: 

"The  inventory  of  a  trading  concern  should  be  valued  at 
cost.  It  has  been  held  that  it  is  proper  to  compute  it  on  the 
basis  of  the  market  value,  if  such  a  value  is  smaller  than  cost; 
but  it  is  generally  denied  'that  a  market  value  higher  than  cost 
can  be  used.  If  the  lower  value  is  allowed,  there  is  no  reason  why 
the  higher  one  should  not  be.  There  is,  however,  a  good  reason 
why  market  values  should  not  be  used  at  all.  Accounting  is 
not  interested  in  what  would  have  happened  'if,  but  in  what 
has  actually  happened;  and  since  the  goods  unsold  were  pur- 
chased at  a  certain  price,  the  profits  realized  are  to  be  measured 
by  comparing  that  price  with  the  proceeds.  To  reduce  the 
inventory  to  a  value  lower  than  cost,  is  to  add  to  the  cost  of 
the  goods  sold  during  the  period ;  and  to  raise  the  inventory  to 
a  value  greater  than  cost,  is  to  reduce  the  cost  of  the  goods 
during  the  period.  In  either  case,  the  result  is  contrary  to  the 
truth." 

A  quotation  from  William  R.  Basset's  "Accounting  as  an 
Aid  to  Business  Profits"  is  to  be  contrasted  with  the  above: 

"The  rules  for  values  are  arbitrary  and,  to  some  extent, 
unreasonable,  but  they  are  accepted  everywhere  and  bankers 
look  askance  at  any  departure  from  them.  Here  they  are: 

1.  "Value  at  cost. 

2.  "If  the  cost  is  above  the  market,  then  value  at  the 
market. 

3.  "If  the  cost  is  below  the  market,  do  not  raise  the  values — 
keep  them  still  at  cost. 

"It  is  not  logical  to  bring  down  cost  to  the  market  and  at 
the  same  time  refuse  to  raise  the  inventory  if  the  market  is 
above  the  cost;  but  the  procedure  is  so  established  that  it  should 
not  be  departed  from.  And  also  it  does  prevent  a  mere  bookkeep- 
ing profit  from  appearing  as  an  actual  profit.  An  excellent 
practice  is  to  value  according  to  the  above  rules  and  attach  a 

*Author  of  "Applied  Theory  of  Accounts." 


INVENTORIES  99 

footnote  showing  the  increased  values  according  to  market 
prices.  This  gives  the  necessary  information  without  inflation." 

The  latter  seems  to  be  the  more  general  procedure  and 
throughout  this  course  there  will  be  noted  the  fact  that  all 
inventories  have  been  taken  at  cost  or  market  value,  whichever 
is  the  lower. 

In  some  cases  there  would  seem  to  be  just  cause  for  taking 
an  inventory  at  a  price  exceeding  the  cost  price.  For  instance, 
in  determining  the  value  of  stock  on  hand  at  the  time  of  the 
sale  of  a  business,  the  inventory  may  be  taken  at  market  price, 
even  though  it  be  above  cost  price.  In  any  event,  if  an  auditor 
were  asked  to  certify  to  a  statement  in  which  the  inventory 
had  been  taken  at  a  price  higher  than  cost  price,  the  fact  should 
be  noted  either  in  the  Balance  Sheet  or  as  a  footnote  to  it. 

In  a  manufacturing  business  the  inventory  will  usually  be 
subdivided  into  three  parts  as  follows : 

1.  Raw  materials. 

2.  Goods  in  process. 

3.  Finished  goods. 

The  method  of  taking  the  inventory  will  not  vary  from  the 
standpoint  of  valuation  from  that  of  a  trading  concern.  All 
stock  regardless  of  what  stage  it  may  be  in  should  be  priced  at 
cost  or  market,  whichever  may  be  the  lower.  The  cost  price  of 
raw  materials  can  always  be  determined  from  the  purchase 
records.  The  price  of  goods  in  process  will  not  be  so  easily 
determined.  During  the  process  of  manufacturing  the  cost 
increases  until  at  the  time  the  goods  are  finished  they  represent 
to  the  manufacturing  concern  the  same  as  merchandise  does  to 
the  trading  concern.  In  other  words,  the  finished  goods  of  the 
manufacturer  is  the  stock-in-trade.  There  are  three  items  of  cost 
to  consider  in  determining  the  inventory  value  of  goods  in  pro- 
cess: 

1.  Cost  price  of  raw  materials  consumed. 

2.  Direct  labor. 

3.  Factory  overhead  or  manufacturing  expenses. 
The  inventory  value  of  finished  goods  will  be  the  same  as  the 

cost  of  production.  The  cost  of  production  here  is  to  the  manufac- 
turer what  the  cost  of  merchandise  purchased  is  to  the  merchant. 

Turnover.  The  rate  of  "turnover"  is  the  number  of 
times  a  firm  "turns"  its  stock  during  the  year.  For  instance, 
when  a  stock  of  goods  has  been  purchased  and  has  been  sold, 
it  is  known  as  a  turnover;  if  the  money  is  reinvested  in  another 
stock  of  goods  and  this  is  disposed  of  within  the  year, 
there  is  said  to  have  been  a  second  turnover.  The  process  of 
determining  the  rate  of  turnover  seems  to  vary  with  different 
authorities.  Montgomery  says: 

"To  ascertain  the  turnover,  take  the  starting  inventory, 
add  the  purchases  or  cost  of  manufactured  goods,  and  deduct 
the  inventory  at  the  end ;  divide  the  total  by  the  starting  in- 
ventory. The  calculations  are  based  upon  a  normal  inventory. 


ioo  PUBLIC  ACCOUNTING  AND  AUDITING 

The  result  will  be  the  number  of  times  the  capital    invested 
in   stock-in-trade   has   been   turned   over  during   the    period." 

It  will,  therefore,  be  seen  that  according  to  Mr.  Mont- 
gomery's idea  the  turnover  would  be  found  by  dividing  the 
COST  OF  SALES  by  the  beginning  inventory,  provided  that 
inventory  is  a  normal  inventory.  In  order  to  determine  whether 
it  is  a  normal  inventory  or  not,  it  would  be  best  to  average  the 
inventory  for  a  period  of  years  If  the  inventories  for  a  period 
of,  say,  five  years  were  used  in  determining  the  average,  and  it 
approximated  the  same  as  the  inventory  for  the  present  year, 
then  it  will  be  seen  that  it  constitutes  a  normal  inventory. 
This  seems  to  be  the  more  uniform  practice.  However,  it  is 
well  to  give  consideration  to  what  others  have  to  say  on  the 
matter.  Walton  says: 

'If  we  adopt  working  capital  as  the  basis  of  the  turnover 
the  difficulty  disappears,  because  the  amount  of  working  capital 
is  indicated  in  the  Balance  Sheet,  if  we  adopt  the  definition  of 
working  capital  as  that  part  of  the  proprietorship  not  tied  up 
in  fixed  assets,  in  other  words,  the  excess  of  current  assets  over 
current  liabilities.  Except  as  affected  by  the  slight  increase  due 
to  accumulating  undistributed  profits,  it  remains  the  same 
throughout  the  entire  period  and  therefore  affords  a  stable 
basis  of  comparison. 

"The  use  of  working  capital  as  the  basis  of  turnover  is 
logical  because  it  was  put  in  the  business  for  the  purpose  of 
being  turned  over  as  rapidly  as  possible,  because  it  is  virtually 
constant,  and  because  it  represents  all  the  elements  concerned 
in  the  turnover — not  only  the  stock-in-trade,  but  also  the  ac- 
counts and  notes  receivable  that  are  the  means  by  which  the 
turnover  is  effected." 

The  difficulty  with  this  theory  lies  in  determining  the  mean- 
ing of  the  term  "working  capital."  H.  R.  Hatfield*  says: 

"Working  capital  has  long  had  a  specific  meaning  as  a 
collective  term  for  what  are  often  called  quick  assets,  e.  g., 
cash,  accounts  receivable,  perhaps  merchandise,  etc." 

H.  C.  Bentleyt  says:  "Working  capital  is  the  excess  of  quick 
assets  over  quick  liabilities." 

Walton  considers  Bentley's  definition  as  the  correct 
one.  At  any  rate,  he  further  says:  "It  is  in  my  opinion  the 
accounting  view  of  what  capital  is."  Therefore,  the  whole 
problem  is  narrowed  down  to  the  question  as  to  whether  we 
are  to  consider  the  normal  inventory  as  the  basis  of  a  turnover, 
or  whether  we  are  to  consider  the  working  capital  as  the  basis. 
It  is  unfortunate  that  accountants  cannot  find  some  means  for 
arriving  at  uniformity  in  practice  with  reference  to  the  more 
important  accounting  principles. 

Determining  the  Value  of  Merchandise  Destroyed  by 
Fire.  All  business  men  anticipate  the  possibility  of  a  fire,  but 
few  give  thought  to  how  they  will  collect  their  insurance.  Fre- 
quently settlement  must  be  made  upon  a  basis  satisfactory  only 

*Author  of  "Modern  Accounting." 
fAuthor  of  "Science  of  Accounts." 


INVENTORIES  101 

to  the  insurance  company  for  the  reason  that  the  business  man  is 
unable  to  prove  what  has  been  destroyed  and  the  value  thereof. 

A  properly  authenticated  Balance  Sheet  certified  to  by  a 
public  accountant  is  a  material  aid  in  the  adjustment  of  claims 
as  has  often  been  demonstrated  in  practice.  Where  an  inventory 
is  not  available  at  the  time  of  fire,  the  claim  is  usually  adjusted  by 
using  the  "gross  trading  profit"  test.  The  average  gross  trad- 
ing profit  in  prior  periods  is  used  as  the  basis  of  determining 
the  cost  of  sales.  Deduct  the  average  gross  trading  profit  from 
sales  and  the  result  is  the  cost  of  sales.  Having  determined  this, 
take  the  last  known  or  recorded  inventory,  add  purchases  to 
date  of  fire  and  deduct  cost  of  sales.  The  result  is  the  inventory 
at  time  of  fire.  If  a  perpetual  inventory  has  been  maintained 
and  the  last  Balance  Sheet  prepared  by  a  Certified  Public  Ac- 
countant, no  compromise  with  the  insurance  company  need  be 
made,  but  allowance  for  the  full  amount  of  the  claim  may  be 
insisted  upon. 

2.    AUDITING  THEORY 

Quoting  from  Federal  Reserve  Bulletin : 

Inventory  Must  Include  Only  Goods  Owned.  "Under 
this  caption  must  be  included  only  stocks  of  goods  owned  and 
under  control  of  the  owner.  Stocks  are  often  hypothecated  and 
if  this  is  the  case  the  fact  should  be  stated  on  the  Balance  Sheet . 

Beginning  Inventory  Must  Be  Verified.  "Inasmuch  as 
the  accuracy  of  the  Profit  and  Loss  account  is  absolutely  de- 
pendent upon  the  accuracy  of  the  inventories  of  merchandise 
at  the  beginning  and  end  of  the  period  under  review,  this  part 
of  the  verification  should  receive  special  attention.  When  a 
Balance  Sheet  audit  is  being  made  for  the  first  time,  the  inven- 
tory at  the  beginning  of  the  period  should  receive  as  much  atten- 
tion as  that  at  the  end,  and  the  auditor  should  take  every  precau- 
tion to  satisfy  himself  that  both  inventories  were  taken  on  the 
same  basis. 

Audit  Program.  "An  acceptable  program  of  audit  for 
inventories  is  as  follows: 

Stock  Sheets,  "(i)  Secure  the  original  stock  sheets  if  they 
are  in  existence  and  carefully  test  the  typewritten  copies  with 
them  and  with  tickets,  cards,  or  other  memoranda  that  show 
the  original  count. 

Inventory  Certificate.  "(2)  See  that  the  sheets  are  cer- 
tified to  or  initialed  by  the  persons  who  took  the  stock,  made  the 
calculations  and  footings,  and  fixed  the  prices,  and  satisfy  yourself 
that  they  are  dependable  and  responsible  persons.  Obtain  a  clear 
and  detailed  statement  in  writing  as  to  the  method  followed  in 
taking  stock  and  pricing  it;  also  a  certificate  from  a  responsible 
head  as  to  the  accuracy  of  the  inventory  as  a  whole. 

Footings  and  Extensions.  "(3)  A  thorough  test  of  the 
accuracy  of  the  footings  and  extensions  should  be  made,  espe- 
cially of  all  large  items. 


102  PUBLIC  ACCOUNTING  AND  AUDITING 

Discrepancies.  "(4)  The  inventories  should  be  compared 
with  the  stores  ledger,  work  in  progress  ledgers  and  finished 
product  records  and  stock  records  as  to  quantities,  prices  and 
values,  and  any  material  discrepancy  should  be  thoroughly  traced. 

Book  Inventory.  "(5)  Where  stock  records  are  kept  and 
no  physical  inventory  is  taken  at  the  time  of  the  audit,  ascertain 
when  the  last  physical  inventory  was  taken  and  compare  it  with 
the  book  records.  If  no  recent  comparison  is  possible,  select 
a  few  book  items  of  importance  and  personally  compare  with 
the  actual  stock  on  hand. 

Physical  Inventory.  "(6)  Where  no  stock  records  are  kept, 
a  physical  inventory  should  be  taken  preferably  under  the  general 
direction  of  the  auditor.  After  the  inventory  is  completed,  he 
should  apply  the  same  tests  to  verify  its  accuracy  as  if  the 
inventory  had  been  taken  before  his  arrival  upon  the  scene. 

Inadequate  Cost  Systems.  "(7)  When  the  cost  system 
of  a  company  does  not  form  a  part  of  the  financial  accounting 
scheme  there  is  always  a  chance  that  orders  might  be  completed 
and  billed,  but  not  taken  out  of  the  work  in  progress  records. 
Especially  is  this  the  case  when  reliance  is  placed  on  such  records 
to  the  extent  that  a  physical  inventory  is  not  taken  at  the  end 
of  the  period  to  verify  the  information  shown  therein.  In  these 
cases  the  sales  for  the  month  preceding  the  close  of  the  fiscal 
period  should  be  carefully  compared  with  the  orders  in  progress 
as  shown  by  the  inventory,  to  see  that  nothing  that  has  been 
shipped  is  included  in  the  inventory  in  error.  Cost  systems 
which  are  not  coordinated  with  the  financial  accounts  are  un- 
reliable and  frequently  misleading.  Special  attention  should  be 
called  to  every  case  in  which  the  cost  system  is  not  adequately 
checked  by  the  results  of  the  financial  accounting. 

Goods  in  Transit.  "(8)  Ascertain  that  purchase  invoices 
for  all  stock  included  in  the  inventory  have  been  entered  on  the 
books.  Look  for  post  dated  invoices  and  give  special  attention 
to  goods  in  transit. 

Consigned  Goods.  "(9)  See  that  nothing  is  included  in 
the  inventory  which  is  not  owned  but  is  on  consignment  from 
others.  If  goods  consigned  to  others  are  included,  see  that  cost 
prices  are  placed  thereon,  less  a  proper  allowance  for  loss,  damage, 
or  expenses  of  possible  subsequent  return.  This  does  not  include 
goods  at  branches,  as  the  valuing  of  such  stocks  will  be  governed 
by  the  same  principles  as  apply  at  the  head  office. 

Goods  Awaiting  Shipment.  "  ( i o)  Ascertain  that  nothing 
is  included  which  has  been  sold  and  billed,  and  is  simply  awaiting 
shipment. 

Legitimate  Costs,  "(n)  If  duties,  freight,  insurance,  and 
other  direct  charges  have  been  added,  test  them  to  ascertain  that 
no  error  has  been  made.  Duties  and  freight  are  legitimate  ad- 
ditions to  the  cost  price  of  goods,  but  no  other  items  should  be 
added  except  under  unusual  circumstances. 


INVENTORIES  103 

Obsolete  Stock.  "(12)  As  a  check  against  obsolete  or 
damaged  stock  being  carried  in  the  inventory  at  an  excessive 
valuation,  the  detailed  records  for  stores,  supplies,  work  in  prog- 
ress, finished  products,  and  purchased  stock  in  trade,  should 
be  examined  and  a  list  prepared  of  inactive  stock  accounts, 
which  should  be  discussed  with  the  company's  officials  and 
satisfactory  explanations  obtained. 

Cost  or  Market  Price.  "(13)  The  auditor  should  satisfy 
himself  that  inventories  are  stated  at  cost  or  market  prices, 
whichever  are  the  lower  at  the  date  of  the  Balance  Sheet.  No 
inventory  must  be  passed  which  has  been  marked  up  to  market 
prices  and  a  profit  assumed  that  is  not  and  may  never  be  realized. 
If  the  market  is  higher  than  cost,  it  is  permissible  to  state  that 
fact  in  a  footnote  on  the  Balance  Sheet. 

Average  Price  Used.  "(14)  It  may  be  found  that  inven- 
tories are  valued  at  the  average  prices  of  raw  materials  and 
supplies  on  hand  at  the  end  of  the  period.  In  such  cases  the 
averages  should  be  compared  with  the  latest  invoices  in  order 
to  verify  the  fact  that  they  are  not  in  excess  of  the  latest  prices, 
and  also  with  the  trade  papers,  when  market  prices  are  used,  to 
see  that  they  are  not  in  excess  of  market  values. 

Reasonable  Quantities.  "(15)  Make  an  independent 
inspection  of  the  inventory  sheets  to  determine  whether  or  not  the 
quantities  are  reasonable,  and  whether  they  accord  in  particular 
instances  with  the  average  consumption  and  average  purchases 
over  a  fixed  period.  Abnormally  large  quantities  of  stock  on  hand 
may  be  the  legitimate  result  of  shrewd  foresight  in  buying  in  a 
low  market,  but  may,  on  the  other  hand,  arise  from  serious  errors 
in  stock  taking. 

Gross  Profit  Test.  "(16)  Always  attempt  to  check  the 
totals  by  the  'gross  profit  test'  and  compare  the  percentage 
of  gross  profit  shown  with  that  of  previous  years.  In  a  busi- 
ness where  the  average  gross  profit  remains  fairly  constant  this 
test  is  a  dependable  one,  because,  if  the  rate  of  gross  profit  is 
apparently  not  maintained  and  the  discrepancy  can  not  be  satis- 
factorily accounted  for  by  a  rise  or  fall  in  the  cost  of  produc- 
tion or  of  the  selling  price,  the  difference  will  usually  be  due  to 
errors  in  stock  taking. 

Testing  the  Cost  System.  "(17)  In  verifying  the  prices 
at  which  the  work  in  progress  is  included  in  the  inventory,  a 
general  examination  and  test  of  the  cost  system  in  force  is  the 
best  means  of  doing  this  work  satisfactorily.  In  a  good  cost 
systemtflittle  difficulty  will  be  found  with  the  distribution  of 
the  raw  materials,  stores,  and  pay  roll,  but  the  distribution 
of  factory  overhead  cost  is  one  that  should  receive  careful 
consideration,  the  main  points  to  be  kept  in  view  being: 

"(a)  That  no  selling  expenses,  interest  charges,  or  adminis- 
trative expenses  are  included  in  the  factory  overhead  cost. 


104  PUBLIC  ACCOUNTING  AND  AUDITING 

"(b)  That  the  factory  overhead  cost  is  distributed  over 
the  various  departments,  shops,  and  commodities  on  a  fair  and 
equitable  basis. 

Cost  vs.  Selling  Price.  "(18)  No  profit  should  be  includ- 
ed in  the  price  of  finished  products  or  stock-in-trade.  The  price 
list  should  be  examined  to  see  that  the  cost  prices  of  stock  are 
below  the  selling  prices  after  allowing  for  trade  discounts,  and, 
if  they  are  not,  a  reserve  should  be  set  up  on  the  Balance  Sheet 
for  this  loss.  If  the  company  takes  immediate  steps  to  increase 
the  selling  price,  however,  the  amount  of  this  reserve  may  be 
limited  to  the  loss  on  goods  which  may  have  been  sold  since  the 
close  of  the  period  to  the  date  of  the  discovery. 

Profits  on  Partial  Shipments.  "(19)  In  the  case  of 
companies  manufacturing  large  contracts  it  is  frequently  found 
necessary  to  make  partial  shipments  thereof.  The  question  then 
arises  as  to  whether  it  is  permissible  to  include  the  profits  on 
these  partial  shipments  in  the  Profit  and  Loss  account.  As  a  matter 
of  fact,  it  is  evident  that  the  actual  cost  can  not  be  known  until 
the  order  is  completed.  It  may  be  estimated  that  a  profit  will 
ultimately  be  made,  yet  unforeseen  conditions,  such  as  strikes, 
delays  in  receiving  material,  etc.,  may  arise  to  increase  the  esti- 
mated cost.  It  is  better  not  to  include  the  profits  on  partial 
shipments,  but  information  of  this  character  which  may  have  its 
influence  in  the  decision  of  the  banker  upon  a  proposed  loan 
may  properly  be  laid  before  him.  Of  course,  an  exception  should 
be  made  in  cases  where  the  profit  on  the  partial  shipments 
largely  exceeds  the  selling  price  of  the  balance  of  the  order. 

Contract  Prices.  "(20)  The  selling  prices  for  contract 
work  in  progress  should  be  ascertained  from  the  contracts,  and 
where  it  is  apparent  that  there  will  be  a  loss  on  the  completed 
contract  a  due  proportion  of  the  estimated  loss  should  be  charged 
to  the  period  under  audit  by  setting  up  a  reserve  for  losses  on 
contracts  in  progress. 

Unsalable  Stock.  "(21)  If  a  company  has  discontinued 
the  manufacture  of  any  of  its  products  during  the  year,  the  in- 
ventory of  such  products  should  be  carefully  scrutinized  and, 
if  unsalable,  the  amount  should  be  written  off. 

Charges  to  Fixed  Assets  Must  Not  Be  Included. 
"(22)  The  inventory  should  be  scrutinized  to  see  that  no 
machinery  or  other  material  that  has  been  charged  to  plant  or 
property  account  is  included  therein. 

Partial  Deliveries.  "(23)  Partial  deliveries  received  on 
account  of  purchase  contracts  for  material,  etc.,  should  be 
verified  by  certificates  from  the  contractors,  both  as  to  qifentities 
and  prices. 

Advance  Payments.  "(24)  Advance  payments  on  account 
of  purchase  contracts  for  future  deliveries  should  never  appear 
in  an  inventory,  but  be  shown  on  the  Balance  Sheet  under  a 
separate  heading. 


INVENTORIES  105 

Discounts.  "(25)  Trade  discounts  should  be  deducted  from 
inventory  prices,  but  it  is  not  customary  to  deduct  cash  discounts. 
However,  this  may  be  done  when  it  is  the  trade  practice  so  to  do. 

Turnover.  "(26)  While  the  inventory  is  being  verified,  the 
auditor  should  ascertain  the  aggregate  sales  for  the  last  year.  If 
the  turnover  has  not  been  rapid,  it  may  be  due  to  a  poor  stock 
of  goods.  Some  business  men  dislike  to  sell  below  cost  and 
would  rather  accumulate  a  big  stock  of  old  goods  than  dispose 
of  the  old  and  unseasonable  stock  at  a  sacrifice.  The  usual 
outcome  is  that  the  stock  becomes  unwieldy  and  funds  are 
lacking  to  purchase  new  goods.  The  inventory  and  the  gross 
sales  may,  therefore,  have  a  direct  connection. 

Interest  Not  a  Part  of  Cost.  "(27)  It  may  be  well  to 
reiterate  that  interest,  selling  expenses,  and  administrative  ex- 
penses form  no  part  of  the  cost  of  production,  and  therefore 
should  not  be  included  in  the  inventory  in  any  shape." 


3.    AUDITING  PROCEDURE 

The  inventory  of  December  31,  1918,  was  checked  as  to 
extensions  and  footings.  Also,  tests  were  made  by  actual  count 
of  some  of  the  items  listed.  The  secretary  of  the  Company 
certified  that  the  inventory  represented  only  the  materials  and 
goods  in  process  and  on  hand  at  the  plant  and  in  store  as  ascer- 
tained by  actual  count.  The  total  of  the  inventory  of  materials 
and  work  in  process  amounted  to  $55,000.00;  finished  stock 
$80,000.00. 

It  would  have  been  much  better  had  the  raw  materials  and 
the  work  in  process  been  kept  separate,  but  in  this  case  it  seems 
that  there  were  practically  no  raw  materials  on  hand  other 
than  those  in  process  of  manufacture,  consequently  there  is 
no  separate  item  for  raw  materials.  In  verifying  the  value 
of  the  work  in  process,  it  was  found  that  the  actual  cost  price 
of  the  raw  materials  consumed,  plus  the  direct  labor  and  the 
overhead  factory  expenses  had  been  added.  The  item  of 
$2,875.00,  which  represents  the  factory  pay  roll  accrued,  but 
not  paid,  was  found  to  represent  direct  labor  which  had  not 
been  included  in  the  value  of  the  work  in  process,  as  valued 
at  $55,000.00. 

In  arriving  at  the  value  of  the  finished  goods,  there  was 
taken  into  consideration  the  actual  cost  of  production  which 
included  the  overhead  factory  expenses,  but  no  selling  expenses, 
interest  charges  nor  administrative  expenses  were  included  in 
the  factory  overhead  cost.  A  number  of  items  listed  were 
checked  by  an  actual  count  and  found  to  be  correct.  The 
inventory  was  verified  by  J.  I.  King,  junior  accountant.  All 
extensions  and  footings  were  verified. 


io6  PUBLIC  ACCOUNTING  AND  AUDITING 

4.     INCOME  TAX  PROCEDURE 

Inventories  shall  be  Taken  Upon  such  Basis  as  may  be 
Prescribed. 

Income  Tax  Law.  Section  203.  "That  when- 
ever in  the  opinion  of  the  Commissioner  the  use  of  in- 
ventories is  necessary  in  order  clearly  to  determine  the 
income  of  any  taxpayer,  inventories  shall  be  taken  by 
such  taxpayer  upon  such  basis  as  the  Commissioner, 
with  the  approval  of  the  Secretary,  may  prescribe  as 
conforming  as  nearly  as  may  be  to  the  best  accounting 
practice  in  the  trade  or  business  and  as  most  clearly 
reflecting  the  income." 

Basis  of  Inventory  Valuations.  (T.  D.  2609,  December 
19,  1917.)  "For  the  purpose  of  income  and  excess  profits  tax 
return,  inventories  of  merchandise,  etc.,  and  securities,  will  be 
subject  to  the  following  rules: 

"A.  Inventories  of  supplies,  raw  materials,  work  in  process 
of  production  and  unsold  merchandise  must  be  taken  either 
(a)  at  cost,  or  (b)  at  cost  or  market  price  whichever  is  lower, 
provided  that  the  method  adopted  must  be  adhered  to  in  sub- 
sequent years  unless  another  be  authorized  by  the  Commis- 
sioner of  Internal  Revenue. 

"B.  A  dealer  in  securities  who  in  his  books  of  account 
regularly  inventoried  unsold  securities  on  hand  either  (a)  at  cost 
or  (b)  at  cost  or  market  price  whichever  is  lower,  may,  for  the 
purposes  of  income  and  excess  profits  taxes,  make  his  return  upon 
the  basis  upon  which  his  accounts  are  kept,  provided  that  a 
description  of  the  method  employed  shall  be  included  in  or 
attached  to  the  return,  that  all  the  securities  must  be  inven- 
toried by  the  same  method,  and  that  that  method  must  be 
adhered  to  in  subsequent  years  unless  another  be  authorized  by 
the  Commissioner  of  Internal  Revenue. 

"C.  Gain  or  loss  resulting  from  the  sale  or  disposition  of 
assets  inventoried  as  above  must  be  computed  at  the  difference 
between  the  inventory  value  and  the  price  or  value  at  which 
sold  or  disposed  of. 

"In  all  other  cases  inventories  must  be  taken  at  cost  or 
at  value  as  of  March  i,  1913,  as  the  case  may  be." 

Need  of  Inventories.  (Art.  1581.  Reg.  No.  45,  1918.) 
"In  order  to  reflect  the  net  income  correctly,  inventories  at  the 
beginning  and  ending  of  each  year  are  necessary  in  every  case 
in  which  the  production,  purchase  or  sale  of  merchandise  is  an 
income-producing  factor.  The  inventory  should  include  raw 
materials  and  supplies  on  hand  that  have  been  acquired  for 
sale,  consumption  or  use  in  productive  processes,  together  with 
all  finished  or  partly  finished  goods.  Title  to  the  merchandise 


INVENTORIES  107 

included  in  the  inventory  should  be  vested  in  the  taxpayer  and 
goods  merely  ordered  for  future  delivery  and  for  which  no 
transfer  of  title  has  been  effected  should  be  excluded.  The 
inventory  should  include  merchandise  sold,  but  not  shipped  to 
the  customer  at  the  date  of  the  inventory,  together  with  any 
merchandise  out  upon  consignment,  but  if  such  goods  have 
been  included  in  the  sales  of  the  taxable  year,  they  should  not 
be  taken  in  the  inventory.  It  should  also  include  merchandise 
purchased,  although  not  actually  received,  to  which  title  has 
passed  to  the  purchaser.  In  this  regard  care  should  be  exercised 
to  take  into  the  accounts  all  invoices  or  other  charges  in  respect 
of  merchandise  properly  included  in  the  inventory,  but  which 
is  in  transit  or  for  other  reasons  has  not  been  reduced  to  phys- 
ical possession. 

Valuation  of  Inventories.  (Art.  1582.  Reg.  No.  45, 
1918.)  "Inventories  should  be  valued  at  (a)  cost  or  (b)  cost 
or  market,  whichever  is  lower.  Whichever  basis  is  adopted 
must  be  applied  to  each  item  and  not  merely  to  the  total  of  the 
inventory;  that  is,  if  for  instance  basis  (b)  is  adopted,  the  value 
of  each  item  in  the  inventory  will  be  measured  by  market  if 
that  is  lower  than  cost,  or  by  cost  if  that  is  lower  than  market. 
A  taxpayer  may,  regardless  of  his  past  practice,  adopt  the  basis 
of  cost  or  market,  whichever  is  lower,  for  his  1918  inventory, 
provided  a  disclosure  of  the  fact  and  that  it  represents  a  change 
is  made  in  the  return.  Thereafter  changes  can  be  made  only 
after  permission  is  secured  from  the  Commissioner.  Inven- 
tories should  be  recorded  in  a  legible  manner  and  properly 
computed  and  summarized,  and  should  be  preserved  as  a  part 
of  the  accounting  records  of  the  taxpayer.  Goods  taken  in 
the  inventory  which  have  been  so  intermingled  that  they  can 
not  be  identified  with  specific  invoices  will  be  deemed  to  be 
the  goods  most  recently  purchased." 

Inventories  at  Cost.  (Art.  1583.  Reg.  No.  45,  1918). 
"Cost  means: 

"(i)  In  the  case  of  merchandise  purchased,  the  invoice 
price  less  trade  or  other  discounts  except  strictly  cash  discounts 
approximating  a  fair  interest  rate,  which  may  be  deducted  or 
not  at  the  option  of  the  taxpayer,  provided  a  consistent  course 
is  followed.  To  this  net  invoice  price  should  be  added  trans- 
portation or  other  necessary  charges  incurred  in  acquiring 
possession  of  the  goods. 

"  (2)  In  the  case  of  merchandise  produced  by  the  taxpayer, 
(a)  the  cost  of  raw  materials  and  supplies  entering  into  or  con- 
sumed in  connection  with  the  product,  (b)  expenditures  for 
direct  labor,  (c)  indirect  expenses  incident  to  and  necessary 
for  the  production  of  the  particular  article,  including  in  such  in- 
direct expenses  a  reasonable  proportion  of  management  expenses, 
but  not  including  any  cost  of  selling  or  return  on  capital  whether 
by  way  of  interest  or  profit.  In  any  industry  in  which  the 


io8  PUBLIC  ACCOUNTING  AND  AUDITING 

usual  rules  for  computation  of  cost  of  production  are  inapplic- 
able, costs  may  be  approximated  upon  such  basis  as  may  be 
reasonable  and  in  conformity  with  established  trade  practice 
in  the  particular  industry. 

Inventories  at  Market.  (Art.  1784.  Reg.  No.  45, 
1918.)  "Market  means  the  current  bid  price  prevailing  at  the 
date  of  the  inventory  for  the  particular  merchandise,  and  is 
applicable  to  goods  purchased  and  on  hand  and  to  basic  materials 
in  goods  in  process  of  manufacture  and  in  finished  goods  on 
hand,  exclusive,  however,  of  goods  on  hand  or  in  process  of 
manufacture  for  delivery  upon  firm  sales  contracts  at  fixed 
prices  entered  into  before  the  date  of  the  inventory.  Where 
no  open  market  quotations  are  available  the  taxpayer  must 
use  such  evidence  of  a  fair  market  price  at  the  date  or  dates 
nearest  the  inventory  as  may  be  available  to  him,  such  as  spe- 
cific transactions  in  reasonable  volume  entered  into  in  good 
faith,  or  compensation  paid  for  cancellation  of  contracts  for 
purchase  commitments.  The  burden  of  proof  will  rest  upon 
the  taxpayer  in  each  case  to  satisfy  the  Commissioner  of  the 
correctness  of  the  prices  adopted.  It  is  recognized  that  in  the 
latter  part  of  1918,  by  reason  among  other  things  of  govern- 
mental control  not  having  been  relinquished,  conditions  were 
abnormal  and  in  many  commodities  there  was  no  such  scale 
of  trading  as  to  establish  a  free  market.  In  such  a  case,  when 
a  market  has  been  established  during  the  succeeding  year,  a 
claim  may  be  filed  for  any  loss  sustained  in  accordance  with 
the  provisions  of  section  214  (a)  (12)  or  section  234  (a)  (14) 
of  the  statute. 

Adjustment  of  Inventories  After  Close  of 
Taxable  Year.  Income  Tax  Law.  Sec.  214. 
(a-12)  [Individuals.]  (a-14)  [Corporations.]  "At 
the  time  of  filing  return  for  the  taxable  year  1918  a 
taxpayer  may  file  a  claim  in  abatement  based  on  the  fact 
that  he  has  sustained  a  substantial  loss  (whether  or  not 
actually  realized  by  sale  or  other  disposition  resulting 
from  any  material  reductions  (not  due  to  temporary  fluc- 
tuation) of  the  value  of  the  inventory  for  such  taxable 
year,  or  from  the  actual  payment  after  the  close  of  such 
taxable  year  of  rebates  in  pursuance  of  contracts  entered 
into  during  such  year  upon  sales  made  during  such  year. 
In  such  case  payment  of  the  amount  of  the  tax  covered 
by  such  claim  shall  not  be  required  until  the  claim  is  de- 
cided, but  the  taxpayer  shall  accompany  his  claim  with  a 
bond  in  double  the  amount  of  the  tax  covered  by  tha 
claim,  with  sureties  satisfactory  to  the  Commissioner, 
conditioned  for  the  payment  of  any  part  of  such  tax 
found  to  be  due,  with  interest.  If  any  part  of  such 
claim  is  disallowed  then  the  remainder  of  the  tax  due 
shall  on  notice  and  demand  by  the  collector  be  paid 


INVENTORIES  109 

by  the  taxpayer  with  interest  at  the  rate  of  I  per  centum 
per  month  from  the  time  the  tax  would  have  been  due 
had  no  such  claim  been  filed.  If  it  is  shown  to  the 
satisfaction  of  the  Commissioner  that  such  substantial 
loss  has  been  sustained,  then  in  computing  the  taxes  im- 
posed by  this  title  and  by  Title  III  the  amount  of  such 
loss  shall  be  deducted  from  the  net  income,  (b)  If  no 
such  claim  is  filed,  but  it  is  shown  to  the  satisfaction  of 
the  Commissioner  that  during  the  taxable  year  1919 
the  taxpayer  has  sustained  a  substantial  loss  of  the  char- 
acter above  described  then  the  amount  of  such  loss  shall 
be  deducted  from  the  net  income  for  the  taxable  year 
1918  and  the  taxes  imposed  by  this  title  and  by  Title  III 
for  such  year  shall  be  redetermined  accordingly.  Any 
amount  found  to  be  due  to  the  taxpayer  upon  the 
basis  of  such  redetermination  shall  be  credited  or 
refunded  to  the  taxpayer  in  accordance  with  the  provi- 
sions of  section  252." 

Inventories  Prescribed  in  Certain  Cases.  (Reg.  No. 
33,  1918,  H353-)  "Gross  income  for  the  purpose  of  returns 
of  manufacturing  companies  shall  consist  of  the  total  sales 
plus  the  inventory  at  the  end  of  the  year  less  the  sum  of  the 
cost  of  goods  or  materials  purchased  during  the  year  and  the 
inventory  at  the  beginning  of  the  year." 

(Reg.  No.  33,  H354-.)  "For  the  purpose  of  returns  gross 
income  of  mercantile  companies  shall  consist  of  the  total  sales 
plus  the  inventory  at  the  end  of  the  year  less  the  sum  of  the 
cost  of  goods  purchased  during  the  year  and  the  inventory  at 
the  beginning  of  the  year." 


I io  PUBLIC  ACCOUNTING  AND  AUDITING 

A.    THEORY  QUESTIONS 

1.  What  duties  and  responsibilities  has  an  auditor  in  con- 
nection with,  inventories  of  goods  on  hand? 

C.  P.  A.  Me.  and  Ore. 

2.  What  is  turnover  and  of  what  use  should  an  auditor 
make  of  it  in  an  audit  of  a  merchandising  business? 

C.  P.  A.  Ind. 

3.  A  manufacturing  company  purchased  a  large  stock  of 
material  during  the  year  at  low  prices,  but  at  the  time  of  the 
annual  inventory  values   had   abnormally   increased.      How,  in 
your  opinion,  should  the  inventory  and  loss  and  gain  be  shown 
on  the  books?  C.  P.  A.  Mich. 

4.  You  are  asked  by  a  client  to  treat  inventories  at  the 
time  of  closing  the  books.     Should  they  be  figured  at  cost  or 
market    price    or   otherwise?      Is    the    common,    old-fashioned 
method  of  adding  the  inventory  of  merchandise  on  hand  to  the 
credit  side  of  the  Merchandise  account  before  closing  the  books, 
theoretically  correct?     Explain  fully.  C.  P.  A  .Mich. 

5.  Explain  what  is  understood   by  a   "book  inventory" 
and  indicate  in  what  circumstances  and  for  what  purposes  you 
would  consider  such  a  record  to  be  of  use  in  a  manufacturing 
business 

(a)  For  current  information. 

(b)  For  use  in  the  preparation  of  interim  statements  of 
accounts. 

(c)  For  use  in  the  preparation  of  final  yearly  or  half- 
yearly  accounts. 

Assuming  your  client  decided  to  rely  entirely  upon  such 
book  records,  what  steps  should  be  taken  to  guard  their  accuracy? 

Inst.  Ex.  1918. 

6.  An    inventory   is   submitted   to   you   certified   by   the 
manager  of  a  business.     Mention  some  of  the  principal  steps 
you  would  take  to  confirm  the  correctness  of  the  inventory 
figure  appearing  in  the  Balance  Sheet.  Inst.  Ex.  1917. 

7.  A  company  which  keeps  no  perpetual  inventory  records 
but  takes  an  inventory  annually  on  December  31,  suffers  a  fire 
loss  on  March   i.     How  would  you  proceed  to  compute  the 
inventory  on  hand  at  that  date?  Inst.  Ex.  1917. 

8.  "Inventory  of  merchandise  should  be  carried  at  cost 
or  market,  whichever  is  lower."    Do  you  assent  to  this  proposi- 
tion?     Can    you   suggest   circumstances    in   which   you   would 
approve  a  departure  therefrom?     Would  you  be  influenced  by 
events   or   conditions  subsequent   to   the   date   of  closing   the 
accounts?     Give  reasons.  Inst.  Ex.  1918. 


ACCOUNTING  PROBLEMS  in 


B.    ACCOUNTING  PROBLEMS. 

1.  From   the   following  particulars  you  are  required   to 
determine  the  value  of  the  merchandise  on  hand: 

Inventory  at  beginning  of  period $75,000.00 

Purchases 200,000.00 

Wages 65,000.00 

Freight  Inward 3,000.00 

Gross  Profit 56,780.20 

Discount  on  Sales 4,540.00 

Sales 360,784.80 

Discounts  Received  on  Purchases 1,760.00 

C.  P.  A.  Ind. 

2.  Arrange  the  following  in  a  Balance  Sheet  for  presenta- 
tion to  a  banker. 

Furniture  and  Fixtures $15,000.00 

Stock  of  Merchandise  at  cost. .  .     50,000.00 

Accounts  Receivable 35,000.00 

Officers'  Accounts 30,000.00 

Bonds  Owned 10,000.00 

Capital  Stock $75,000.00 

Accounts  Payable 20,000.00 

Trade  Notes  Payable 40,000.00 

Surplus 5,000.00 


$140,000.00     $140,000.00 
C.  P.  A.  111. 

3.  You  are  asked  to  certify  to  the  Balance  Sheet  of  a  cer- 
tain company.    Upon  investigation,  you  find  that  the  inventories 
have  been  priced  at  cost,  although  the  market  prices  at  the 
closing  date  were  10%  lower  on  iron  and  5%  higher  on  wood. 
At  the  date  of  your  report  the  market  on  iron  had  risen  to  5% 
above  cost,  and  the  market  on  wood  had  fallen  to  15%  below 
cost. 

How  would  you  dispose  of  these  items  in  the  Balance  Sheet? 

C.  P.  A.   111. 

4.  You  are  called  in  as  a  public  accountant  to  assist  a 
firm  in  the  preparation  of  a  Balance  Sheet  as  at  December  31, 
1915,  and  in  the  balancing  of  the  books.    After  examination  you 
find  the  following  facts: 

(1)  On  January  3  three  items,  amounting  to  $50,000.00  in 

the  aggregate,  were  received  in  cash,  but  were  entered 
as  at  December  31,  1915.  No  Cash  account  is  kept  in 
the  general  ledger. 

(2)  An  item  was  posted  to  the  credit  of  an  account  in  the 

sales  ledger  from  the  cash  book  as  $5,050.00  instead 
of  $50.50.  A  Sales  Ledger  control  account  is  kept  in 
the  general  ledger. 


ii2  PUBLIC  ACCOUNTING  AND  AUDITING 

(3)  The  Petty  Cash  fund  is  kept  on  the  imprest  system.  On 

December  31,  1915,  a  voucher  covering  expenditures  to 
date  was  passed  and  entered  in  the  Voucher  Register. 
The  check  in  payment  thereof  was  not  entered  in  the 
cash  book  until  January  3,  1916. 

(4)  A  building  had  been  destroyed  by  fire,  and  the  insurance 

recovered  had  been  credited  to  the  asset  account  and 
the  cost  of  replacement  had  been  debited  thereto. 

(5)  An  item  was  posted  to  the  debit  of  the  Interest  account 

in  the  general  ledger  from  the  journal  as  $3.03.  It 
should  have  been  $303.00. 

(6)  Sales  aggregating  $25,000.00  were  entered  on  the  books 

as  at  December  31,  1915,  but  the  goods  were  not  all 

delivered  until  January  25,  1916. 

Indicate  what  adjustments  you  would  make  of  the  books 
or  of  the  accounts  for  the  purpose  of  statement  on  the  Balance 
Sheet.  Give  journal  entries.  C.  P.  A.  111. 

5.  It  is  generally  conceded  that  merchandise  inventories 
should  be  calculated  on  "cost"  prices,  but  in  practice  there  are 
found  many  differences  in  the  method  of  determining  the  cost 
price. 

State  whether  or  not  the  following  items  should  be  regarded 
in  arriving  at  this  cost,  giving  your  reason  in  each  case: 

Cash  discounts. 

Trade  discounts.  ' 

Freight  inward  (on  goods  bought). 

Freight  outward  (on  goods  sold). 

Rebates  and  premiums,  such  as  are  found  in  connec- 
tion with  the  tobacco  business. 

Drayage  and  handling  (inward). 

Packing  and  draying  (outward).  C.  P.  A.  Fla. 

C.     INCOME  TAX  QUESTION 

Should  an  individual  who  conducts  a  grocery,  dry  goods, 
clothing,  or  farm  implement  business,  or  any  other  business 
which  requires  that  a  stock  be  carried,  take  an  inventory  at 
the  close  of  each  taxable  year  and  take  such  inventories  into 
consideration  in  arriving  at  his  net  income  from  business? 
Explain. 


Chapter  Eight 

THE  TRIAL  BALANCE 

In  Chapter  Three  there  was  a  discussion  of  the  general 
ledger  showing  its  control  in  an  accounting  system,  also  a  dis- 
cussion of  the  Trial  Balance.  The  discussion  there,  however, 
was  quite  brief.  It  is  intended  here  to  show  how  an  auditor 
would  proceed  to  verify  all  the  items  in  the  Trial  Balance. 

The  Bookkeeper's  Trial  Balance.  There  is  no  reason 
why  an  auditor  should  not  accept  a  Trial  Balance  offered  him 
by  the  head  bookkeeper  at  the  beginning  of  the  audit,  but  that 
does  not  mean  that  he  need  not  verify  the  items  listed  thereon. 
If  he  were  to  refuse  the  Trial  Balance  offered  him,  the  chances  are 
the  bookkeeper  would  be  offended  and  it  might  lead  to  his  op- 
position instead  of  his  cooperation  during  the  audit.  It  would 
seem  to  be  better  practice,  however,  to  prepare  your  own  Trial 
Balance  even  though  you  have  been  furnished  with  one  by  the 
head  bookkeeper  or  someone  else  in  the  employ  of  the  client. 
Trial  Balances  may  be  made  of  the  subsidiary  ledgers  as  well 
as  of  the  general  ledger,  provided  summary  or  adjustment  ac- 
counts are  maintained  in  the  subsidiary  ledgers.*  Usually,  how- 
ever, no  such  accounts  are  maintained  in  the  subsidiary  ledger, 
therefore,  the  only  way  a  Trial  Balance  can  be  taken  is  to  check 
the  list  of  accounts  taken  from  the  subsidiary  ledger  with  the 
controlling  account  in  the  general  ledger. 

Advantages  of  an  Auditor  Preparing  His  Own  Trial 
Balance.  The  auditor  will  find  that  he  has  a  splendid  oppor- 
tunity to  become  familiar  with  the  details  of  the  accounting 
system  while  preparing  his  Trial  Balance.  He  cannot  help,  in 
going  over  all  the  accounts,  thinking  about  them  and  while  making 
the  necessary  calculations  to  determine  the  correct  balances,  build 
up  in  his  mind  as  he  goes  along  a  general  knowledge  of  the  or- 
ganization as  a  whole. 

*Any  subsidiary  ledger  may  be  made  self-balancing  by  means  of  a  sum- 
mary or  adjustment  account.  This  account  is  set  up  in  the  subsidiary  ledger 
and  is  an  exact  duplicate  of  the  controlling  account  in  the  general  ledger 
except  that  the  sides  ot  the  account  are  reversed  so  that  the  subsidiary  ledger 
account  has  for  its  debits  the  credits  of  the  general  ledger  account,  and  for 
its  credits  the  debits  of  the  general  ledger  account. 

There  is  no  theory  or  principle  of  debit  and  credit  involved  in  this, 
the  device  is  simply  introduced  in  order  that  the  ledger  may  provide  an 
internal  proof  of  its  correctness.  Therefore,  the  total  of  the  balances  of  the 
individual  accounts  in  the  subsidiary  ledger  will  be  offset,  exactly  by  the 
opposite  balance  of  the  one  additional  account,  and  the  ledger  then  is  said 
to  be  self-balancing. 

This  is  not  often  carried  out  for  the  reason  that  it  is  considered  better 
practice  and  more  desirable  for  the  controlling  account  to  be  in  the  hands 
of  another  person  who  thus  has  a  check  upon  the  bookkeeper's  work. 

"3 


114  PUBLIC  ACCOUNTING  AND  AUDITING 

A  Set  of  Books  is  not  Ready  to  be  Audited  Until 
in  Balance.  Some  bookkeepers  and  business  men  think 
that  an  auditor  by  some  sort  of  magic  should  be  able  to 
detect  all  mechanical  errors  in  bookkeeping  and  arrive  at  a 
correct  Trial  Balance  in  a  few  minutes  time.  However,  the  fact 
is  that  it  is  no  part  of  an  auditor's  duty  to  locate  an  error  or  er- 
rors in  a  Trial  Balance  unless  he  has  been  employed  specifically 
to  do  so.  An  auditor  who  accepts  an  engagement  to  perform 
an  audit,  and  who  on  beginning  his  work  finds  that  the  books  are 
not  in  balance,  should  report  the  matter  to  his  client  and  lay 
the  facts  before  him.  He  can,  of  course,  undertake  to  do  the 
necessary  clerical  work  in  order  to  locate  the  errors  in  the  ac- 
counts so  as  to  obtain  a  Trial  Balance,  but  to  do  so  without 
previous  arrangement  with  the  client  is  liable  to  result  in 
difficulties  when  the  bill  for  services  is  presented.  Anyone  who 
spends  his  time  in  ordinary  clerical  work  is  hardly  to  be  considered 
a  professional  auditor  and  it  would  seem  to  be  better  to  permit 
the  bookkeeper  to  locate  his  own  errors  and  obtain  a  Trial 
Balance  before  beginning  the  audit. 

Remuneration  Basis.  In  this  connection  it  is  well  to 
point  out  that  audits  are  made  under  two  classes  of  remunera- 
tion: those  in  which  the  remuneration  is  based  on  a  per  diem 
basis;  and  those  in  which  it  is  being  done  under  a  contract 
specifying  a  certain  sum.  If  the  work  is  being  done  under  a 
contract  and  the  time  necessary  to  do  the  work  has  been  pre- 
viously estimated,  it  would  certainly  be  foolish  to  put  in  a  lot 
of  time  finding  ordinary  clerical  mistakes  in  bookkeeping,  and 
to  do  so  may  result  in  a  loss  on  the  engagement.  If  the  work 
is  being  done  on  a  per  diem  basis,  the  auditor  is  apt  to  become 
involved  in  disagreeable  discussions  with  the  client  because  of 
the  length  of  time  spent  in  performing  the  ordinary  clerical 
work  of  the  bookkeeper.  Consequently,  let  us  point  out  again 
that  the  books  should  be  in  balance  before  the  auditor  begins 
his  work,  and  if  they  are  not  in  balance,  the  bookkeeper  should 
be  given  an  opportunity  to  locate  his  own  errors  and  obtain  a 
Trial  Balance,  after  which,  the  auditor  may  proceed  with  his 
work  in  accordance  with  the  instructions  given  hereinbefore  and 
hereinafter. 

The  Trial  Balance  as  a  Part  of  the  Working  Sheet. 

The  Trial  Balance  is  not  a  financial  statement,  neither  is  it  a 
test  as  to  the  accuracy  of  the  bookkeeping  work.  It  is  merely 
a  list  of  the  balances  of  the  accounts  remaining  open  in  the  ledger. 
Therefore,  it  is  nothing  more  than  a  surface  indication  that  the 
books  are  in  balance  and  that  an  equilibrium  has  been  maintained 
between  the  debits  and  credits.  The  professional  auditor 
usually  prepares  what  is  known  as  a  "Working  Sheet",  the  Trial 
Balance  simply  being  a  part  and  is  represented  by  the  first 
two  columns.  The  Working  Sheet,  in  addition  to  containing 


THE  TRIAL  BALANCE  115 

columns  for  a  Trial  Balance,  should  provide  columns  for  adjust- 
ments, columns  for  the  nominal  accounts  only,  and  columns 
for  the  real  accounts  only.  The  first  two  columns  show  the 
Trial  Balance  taken  at  the  close  of  the  period,  but  before  the 
adjustments  have  been  made.  The  adjustment  columns  show  all 
the  adjustments  and  corrections  made  after  the  Trial  Balance  is 
taken  and  before  the  statements  and  report  are  prepared.  The 
columns  for  nominal  accounts  show  the  profits  and  losses  for 
the  period.  The  columns  for  real  accounts  show  the  assets  and 
liabilities  as  at  the  end  of  the  period  under  audit. 

The  accounts  should  be  arranged  on  the  Working  Sheet  in 
such  a  manner  as  to  provide  the  most  information  and  so  as 
to  make  it  most  convenient  for  the  preparation  of  the  report 
for  the  client  at  the  completion  of  the  audit.  The  accounts 
need  not,  therefore,  be  arranged  in  the  same  order  as  the  arrange- 
ment of  the  accounts  in  the  ledger.  (The  Working  Sheet  will  be 
explained  in  detail  in  a  later  chapter.) 

Procedure  in  Taking  a  Trial  Balance.  First,  prove  each 
account  by  footing  both  sides  of  the  account  and  substracting 
the  two  footings  so  as  to  verify  the  balance.  It  does  not  matter 
whether  this  has  been  done  by  the  bookkeeper  previously  or  not. 
The  auditor  should  make  his  own  verification  independent  of 
that  of  the  bookkeeper. 

Second,  every  page  in  the  ledger  should  be  examined.  Ex- 
perience will  prove  that  some  bookkeepers  have  peculiar  ideas 
with  regard  to  the  arrangement  of  their  accounts,  consequently 
blank  pages  will  be  found  here  and  there  throughout  the  ledger 
and  if  every  page  isn't  examined,  accounts  might  be  omitted. 

Third,  subsidiary  and  memorandum  accounts  may  be  found 
in  the  general  ledger.  For  instance,  one  ledger  may  be  used. 
It  may  be  divided  into  sections;  the  first  section  may  contain 
all  the  assets  and  liabilities  together  with  controlling  accounts 
for  customers  and  creditors ;  the  second  section  of  the  ledger  may 
contain  accounts  with  customers;  and  the  third  section,  accounts 
with  creditors.  On  the  other  hand,  it  is  not  infrequently  found 
that  subsidiary  ledgers  are  kept,  but  no  controlling  accounts 
maintained  in  the  general  ledger.  The  bookkeeper  when  pre- 
paring his  Trial  Balance  simply  makes  a  schedule  from  the 
subsidiary  ledgers  and  uses  the  total  amount  in  his  Trial  Balance. 

Fourth,  some  bookkeepers  seem  to  have  the  idea  that  a 
Cash  account  need  not  be  kept  in  the  general  ledger  simply 
because  a  cash  book  is  kept.  While  it  is  certainly  poor  practice 
to  eliminate  the  Cash  account  in  the  ledger,  yet  such  will  often 
be  the  case,  consequently  a  Trial  Balance  cannot  be  obtained 
unless  the  cash  balance  is  first  obtained  from  the  cash  book 
and  included  in  the  Trial  Balance.  The  only  sound  accounting 
theory  is  that  a  general  ledger  should  balance  independently 
of  all  the  other  books  of  account.  Any  argument  contrary  to 
these  principles  is  certainly  contrary  to  good  accounting  practice. 


Ii6  PUBLIC  ACCOUNTING  AND  AUDITING 

Fifth,  the  first  Trial  Balance  is  usually  taken  after  the  post- 
ing has  been  done  at  the  end  of  the  period  and  before  any  ad- 
justments have  been  made.  The  auditor  will  have  to  be  on  the 
lookout  for  items  posted  to  the  accounts  after  the  bookkeeper 
completed  his  Trial  Balance.  This  is  sure  to  happen  when  an 
audit  is  made  at  a  date  later  than  the  end  of  the  period  under 
audit. 

Quoting  From  The  Federal  Reserve  Bulletin : 

"Trial  Balances  of  the  general  ledger,  both  at  the  beginning 
and  end  of  the  period  under  review,  should  be  prepared  in  com- 
parative form  and  checked  with  the  ledger.  The  items  in  the 
Trial  Balances  should  be  traced  into  the  Balance  Sheets  before 
the  assets  and  liabilities  are  verified,  to  prove,  among  other 
things,  that  no  'contra'  asset  or  liability  has  been  omitted 
from  the  accounts,  that  the  assets  and  liabilities  have  been 
grouped  in  the  same  manner  at  the  beginning  and  at  the  end 
of  the  period,  and  also  that  the  Balance  Sheets  are  in  accordance 
with  the  books.  The  disposition  of  any  general  ledger  assets 
and  liabilities  that  may  have  been  scrapped,  sold,  written  off, 
or  liquidated  during  the  period  under  review  should  be  traced 
and  noted  in  the  working  papers.  Furthermore,  a  general 
scrutiny  of  the  general  ledger  should  be  made  to  see  that  the 
accounts,  if  any,  that  have  been  opened  and  closed  during  the 
year  have  no  bearing  on  the  company's  financial  position  at  the 
close  of  the  fiscal  period." 

ITEMS  NOT  ON  TRIAL  BALANCES 

The  following  quotation  is  taken  from  "Duties  of  the  Junior 
Accountant"  by  Reynolds  and  Thornton,  published  by  the 
American  Institute  of  Accountants: 

"Among  the  items  which  must  be  taken  into  ac- 
count, but  may  not  be  on  the  books,  are  some  which  the 
junior  should  detect  and  take  up  in  every  instance. 
These  are  omissions  from  interdepartmental  balances 
and  balances  between  subsidiary  companies,  goods  in 
transit  and  cash  in  transit. 

"It  is  quite  common  to  find  Trial  Balances,  appar- 
ently in  order,  which  contain  among  'accounts  receiva- 
ble' amounts  due  from  subsidiary  companies  or  from 
departments  of  the  same  company,  and  among  'accounts 
payable'  corresponding  entries,  but  for  differing 
amounts.  Wherever  a  Trial  Balance  shows  any  balance 
due  from  one  department  to  another,  from  one  subsid- 
iary to  another  or  from  either  to  the  principal  company 
the  auditor  must  see  that  the  entry  is  exactly  offset  by  a 
corresponding  item  in  the  accounts  of  the  subsidiary  or 
department  concerned.  If  a  department  carry  as  an 
asset  an  amount  due  from  another  department  and  the 


THE  TRIAL  BALANCE  n? 

second  department  does  not  show  any  liability  in  respect 
thereto  the  accounts  as  a  whole  contain  an  inflation  of 
net  assets,  and  the  auditor  can  so  easily  find  such  an 
error  that  no  excuse  for  failing  to  do  so  will  be  admitted. 

"Where  subsidiary  companies  are  concerned  the  de- 
tection of  such  errors  is  equally  easy  if  the  auditor  has 
access  to  books  of  subsidiaries. 

"The  detection  of  omission  from  inventories  of 
goods  in  transit  and  of  cash  in  transit  are  dealt  with 
under  appropriate  headings  herein. 

"To  sum  up  this  section,  let  the  auditor,  whenever 
he  has  access  to  books  showing  both  sides  of  a  trans- 
action, compare  the  two  entries  and  agree  the  resulting 
balances." 

Results  of  the  Senior's  Checking  the  Trial  Balance. 

The  senior  checked  the  Trial  Balance  himself  because  of  the 
opportunity  it  offers  to  gain  an  insight  into  the  nature  of  the 
organization  and  of  the  business  conducted.  His  working 
papers  show  the  following: 

First,  he  found  that  the  information  referred  to  in  the  audit 
of  accounts  receivable  in  Chapter  Six  is  correct.  The  total  of  the 
debit  balances  of  the  customers'  accounts  in  the  sales  ledger 
amount  to  $84,721.50.  The  total  of  the  credit  balances  amount 
to  $3,034.50.  The  difference  between  the  debit  and  credit 
balances  is  equal  to  the  balance  of  the  controlling  account  in 
the  general  ledger,  amounting  to  $81,687.00. 

Second,  he  reports  an  offsetting  error  in  footing  the  accounts. 
The  debit  side  of  the  account  with  Salary  Advances  to  Salesmen 
was  overfooted  $30.00,  and  the  account  with  Sales  was  over- 
footed  $30.00  on  the  credit  side. 

Third,  he  found  an  error  in  principle.  An  expenditure 
amounting  to  $215.00  for  a  new  machine  in  the  factory  was 
charged  to  Tools  and  Implements  instead  of  to  Machinery. 
Investigation  shows  plainly  that  it  should  be  a  charge  to  the 
Machinery  account. 

Fourth,  he  notes  an  error  in  the  working  papers  of  J.  I.  King 
with  reference  to  listing  of  notes  receivable.  Reference  to  page  69 
of  Chapter  Five  will  show  that  Mr.  King  listed  the  notes  receiv- 
able. His  papers  show  that  two  notes  were  discounted,  December 
i,  1918.  If  that  were  the  case,  then  the  face  of  those  notes  should 
either  have  been  credited  to  the  Notes  Receivable  account  or  to 
an  account  with  Notes  Receivable  Discounted.  Inasmuch  as 
the  Trial  Balance  does  not  indicate  an  account  in  the  general 
ledger  with  Notes  Receivable  Discounted,  it  is  apparent,  even 
without  an  examination,  that  no  such  an  account  is  maintained. 
Therefore,  notes  receivable  discounted  were  credited  to  the 
Notes  Receivable  account,  consequently,  would  not  be  included 
in  the  total  of  notes  receivable  on  hand  and  would^^not 


Ii8  PUBLIC  ACCOUNTING  AND  AUDITING 

appear  as  a  part  of  the  balance  of  that  account  in  the  Trial 
Balance.  The  Trial  Balance  prepared  by  Mr.  Shields  and  handed 
to  the  senior  at  the  beginning  of  the  audit  lists  notes  receivable,  in 
amount  $12,906.00.  The  Working  Sheet  of  the  junior  shows  the 
same  total,  but  he  makes  no  comment  relative  to  the  notes 
receivable  discounted  except  to  say  that  they  were  verified 
at  the  bank. 

Mr.  King  states  that  the  error  is  in  the  date  of  discount. 
He  claims  that  he  made  an  error  in  indicating  "December  i,  1918" 
as  the  date  of  discount.  It  should  have  been  "January  I,  1919". 
He  says  the  error  was  due  to  a  mistake  in  copying  his  report. 

Advice  to  Juniors.  It  is  in  order  here  to  point  out  the  ad- 
visability of  using  the  utmost  caution  in  the  preparation  of  all 
working  papers  and  reports.  Carelessness  is  not  excusable. 
Accounting  firms  employ  extra  juniors  during  the  busy  season. 
Those  juniors  who  are  competent  and  accurate  in  their  work 
are  the  ones  likely  to  be  retained  permanently,  while  those 
incompetent,  inaccurate  and  careless  in  their  work  are  the  ones 
who  will  be  the  first  to  be  let  go.  Seniors  frequently  are  asked 
to  name  the  juniors  they  wish  to  work  with  them  on  certain 
engagements.  The  mere  fact  that  certain  juniors  are  asked 
for  frequently  by  the  seniors  is  evidence  as  to  the  quality  of 
their  work  and  is  in  itself  a  recommendation.  While  a  junior 
who  is  not  asked,  but  who  is  used  only  because  no  one  else  is 
available,  is  certainly  at  fault  in  some  manner  and  he  needs 
to  take  an  inventory  of  himself  and  determine  his  weakness. 
Mr.  King,  the  junior  mentioned  above,  may  or  may  not  be  at 
fault,  the  fact  remains,  however,  that  he  made  an  error  although 
he  states  that  he  simply  erred  in  copying  his  report  from  hastily 
written  notes  made  on  the  day  of  the  audit. 

READING  THE  MINUTES 

Without  a  doubt  the  minutes  should  be  read  as  early 
after  the  audit  is  begun  as  may  be  practical.  They  will  give 
an  authoritative  insight  into  the  organization  that  can  not  be 
gained  in  any  other  way;  consequently,  the  auditor  will  be  pre- 
pared to  do  more  intelligent  work  in  completing  the  audit. 
He  will  know  whom  to  consult  in  case  any  further  information 
is  desired  because  the  minutes  show  who  the  officers  are  and 
what  their  duties  and  responsibilities  are. 

The  minutes  of  the  stockholders,  board  of  directors,  the  ex- 
ecutive committee,  and  any  special  committees  should  be  read. 
The  articles  of  incorporation  will  usually  be  embodied  in  the 
minutes  of  the  stockholders,  but  if  not,  the  auditor  should  ask 
for  a  copy  of  the  articles  or  for  a  certificate  of  incorporation. 
These  are  sometimes  known  as  the  charter.  The  auditor  should 
note  in  his  working  papers  the  exact  name  of  the  corporation, 
the  date  the  certificate  was  filed,  the  authorized  capital  stock 


THE  MINUTES  n9 

showing  the  kind  of  stock,  the  par  value  of  each  share  and  the 
number  of  shares,  the  names  of  the  incorporators,  and  any 
other  information  likely  to  be  of  benefit  in  the  preparation  of 
the  report.  It  is  better  to  write  down  more  than  will  ever  be 
used  than  to  find  when  making  the  report  that  certain  infor- 
mation is  necessary  and  that  he  failed  to  make  note  of  it  in  his 
working  papers.  The  •  importance  of  this  statement  will  be 
understood  when  it  is  considered  that  frequently  an  audit  is 
made  in  a  distant  city,  while  the  report  will  be  prepared  in  the 
office.  The  audit  might  be  made  in  Seattle  and  the  report  might 
be  written  in  Boston.  Therefore,  it  would  be  quite  embarrassing 
to  learn  that  all  the  information  desired  had  not  been  obtained. 

The  minutes  of  the  stockholders  should  be  examined  with 
regard  to  election  of  officers,  compensation  of  officers,  bond  of 
the  treasurer,  contracts  with  the  manager  and  other  employees, 
any  special  contracts  that  may  exist,  resolution  fixing  the  value 
of  property  purchased  and  the  rates  of  depreciation,  etc.  The 
minutes  of  the  board  of  directors  should  be  examined  for  ad- 
ditional information. 

An  executive  committee  often  exists  in  a  corporation.  It 
may  be  composed  of  three  or  more  members  of  the  directors 
and  its  purpose  is  to  facilitate  certain  features  of  the  work. 
Financial  matters  are  usually  looked  after  by  this  committee, 
and  it  often  outlines  the  financial  program  and  has  authority 
to  make  appropriations,  etc. 

In  the  case  of  a  corporation  the  by-laws  will  often  furnish 
additional  information  and  should  undoubtedly  be  read.  One 
cannot  become  too  well  acquainted  with  the  organization  and 
its  details. 

The  author  had  an  experience  that  may  be  of  interest  to 
some.  He  was  employed  by  a  man  conducting  a  milling  business 
to  install  a  system  of  accounts  involving  a  cost  system.  Pre- 
liminary to  the  installation  of  the  system  of  accounts,  he  was 
asked  to  make  a  partial  audit  so  as  to  insure  a  proper  financial 
statement  at  the  time  the  new  system  was  installed.  When 
employed  by  the  client,  he  was  informed  that  the  business  was 
a  partnership,  but  when  he  asked  for  the  copartnership  agree- 
ment, he  learned  that  none  existed  and  finally  obtained  the 
information  that  the  business  was  owned  solely  by  the  father 
of  the  client  and  that  the  client's  position  was  that  of  a  manager. 
Before  proceeding  further  a  conversation  was  held  with  the 
father  and  thereby,  in  addition  to  establishing  the  responsibility 
and  authority  of  the  client,  information  was  secured  that 
aided  materially  in  opening  the  books  after  devising  a  system 
of  accounts. 


120  PUBLIC  ACCOUNTING  AND  AUDITING 


FIXED  ASSETS 

Having  completed  the  audit  of  the  current  assets,  the  fixed 
assets  will  be  taken  up  in  the  order  in  which  they  appear  in  the 
Trial  Balance  of  The  Blank  Manufacturing  Company  as  shown 
on  page  50  of  Chapter  Four.  The  following  accounts  classified 
as  fixed  assets  appear  therein : 

Land $  100,000.00 

Buildings 150,000.00 

Machinery 100,000.00 

Tools  and  Implements 20,215.00 

Horses,  Wagons  and  Harness 15,000.00 

Office  Furniture 2,600.50 

Following  these  accounts  a  discussion  of  depreciation  will 
be  given  (see  Chapter  Ten).  The  object,  of  course,  is  to  deter- 
mine the  true  value  of  each  asset,  and  the  method  the  auditor 
used  in  arriving  at  the  value. 

Real  Estate.  The  following  discussion  appears  in  2Oth 
CENTURY  BOOKKEEPING  AND  ACCOUNTING:  (See 
page  87) 

"Real  Estate  is  a  technical  term  that  is  applied  to 
immovable  property  which  consists  of  land,  buildings 
and  other  improvements  which  make  the  land  valuable. 
Real  estate  may  be  purchased  by  a  business  (a)  for  a 
home,  or  (b)  for  speculation.  When  it  is  purchased  as 
a  speculation  a  separate  account  should  be  opened  for 
each  property  owned. 

"The  purchase  price  fixes  the  value  of  the  real 
estate,  and  this  value  does  not  change  except  in  the  case 
of  additional  improvements.  The  value  should  not 
be  increased  by  means  of  an  inventory  or  appraisal  for 
no  profit  can  be  realized  until  it  is  sold.  A  distinction 
should  be  made  between  the  land  and  the  buildings,  be- 
cause the  buildings  decrease  in  value  owing  to  age  and 
use,  while  the  land  does  not.  On  account  of  this  distinc- 
tion their  value  should  be  separated  at  the  time  of  pur- 
chase. Accountants  recommend  that  separate  accounts 
be  kept  with  land  and  buildings.  If  only  one  account 
is  kept,  their  separate  value  should  be  indicated  by  the 
use  of  the  explanation  column.  In  either  case  an  ac- 
count termed  Building  Expense  and  Revenue  should  be 
kept  to  record  all  expenses  incident  to  the  upkeep  of  the 
buildings,  and  income  which  may  be  derived  from  the 
rental  of  any  portion  of  the  building. 

"If  the  building  is  to  be  constructed  on  land  pur- 


LAND  121 

chased  for  this  purpose,  the  purchase  price  of  the  land 
together  with  any  additional  cost  of  grading  and  prepar- 
ing it  for  the  building,  is  charged  to  the  Land  account. 
Payments  in  connection  with  the  construction  of  the 
building  are  charged  to  a  Building  Contract  account. 
When  the  building  is  completed,  the  balance  of  this 
account  is  closed  into  a  Building  account.  This  is  car- 
ried on  the  books  as  the  value  of  the  building,  and  the 
depreciation  is  based  on  it." 

Many  bookkeepers  will  keep  an  account  with  Real  Estate  or 
some  similar  term  and  the  account  will  represent  both  the  land 
and  the  buildings  thereon.  In  fact,  some  of  our  bookkeeping  texts 
still  illustrate  an  account  of  this  kind,  consequently,  there  are 
thousands  of  students  each  year  who  are  taught  that  land  and 
buildings  may  be  grouped  in  one  account.  To  state  that  it  is 
poor  practice  is  putting  it  mildly.  The  accountant  will  always 
insist  that  land  and  buildings  be  kept  separate  in  the  accounts 
because  of  the  difference  in  the  nature  of  the  items. 

Esquerre'  says: 

"The  components  of  the  cost  of  plant  land  vary 
materially  from  those  of  investment  land ;  the  consider- 
ation of  increases  in  market  values,  while  of  much  im- 
portance in  the  case  of  the  latter,  is  merely  an  incident 
in  the  case  of  the  former,  since  the  asset  cannot  or- 
dinarily be  sold  without  causing  operations  to  come  to 
an  end,  at  least  temporarily.  On  the  other  hand,  build- 
ings depreciate  through  wear  and  tear,  while  land  does 
not;  hence,  if  reserves  are  created  for  the  depreciation 
of  buildings,  and  applied  for  Balance  Sheet  purposes  to 
Land  and  Buildings  account,  it  is  not  possible  to  as- 
certain the  book  value  of  the  asset  which  the  deprecia- 
tion affects. 

"These  accounting  differences  in  the  nature  of  the 
two  values,  land  and  buildings,  would  seem  to  be  suf- 
ficient to  cause  the  creation  of  two  distinct  accounts 
with  them,  and  are  generally  so  regarded." 
In  the  preparation  of  a  Balance  Sheet  the  value  of  the  land 
should  always  be  listed  as  a  separate  item  and  should  never  be 
included  with  the  value  of  the  buildings  for  the  reason  that 
the  depreciation  on  buildings  does  not  affect  the  value  of  the 
land.     Furthermore,  good  practice  demands  that  the  value  of 
the  land  used  in  the  business  should  be  listed  separately  from 
land  representing  investments. 

The  Theory  of  the  Land  Account.  This  discussion  is 
confined  to  land  used  in  the  business.  It  is  the  most  permanent 
asset  owned  by  a  business  enterprise.  Land  should  appear  in 
the  Balance  Sheet  at  cost,  regardless  of  what  the  market  value 
may  be.  In  fact  the  market  value  is  never  known  unless  a  sale 
is  made.  The  object  of  the  Land  account  is  to  show  the  cost, 


122  PUBLIC  ACCOUNTING  AND  AUDITING 

therefore,  it  should  be  debited  or  charged  with  (a)  the  original 
cost;  (b)  the  expenses  incident  to  the  purchase,  such  as  cost  of 
investigating  the  title,  recording  the  deed,  commissions  to  real 
estate  agent,  and  any  other  expenses  that  clearly  add  to  the  cost 
of  the  purchase;  (c)  the  cost  of  improvements  that  increase  the 
value  of  the  land,  such  as  fencing,  draining,  leveling,  filling  in, 
building  approaches,  sidewalks,  etc. 

It  is  not  always  an  easy  matter  to  determine  when  expendi- 
tures are  an  actual  improvement  to  the  land.  The  auditor 
must  examine  carefully  all  charges  to  this  account.  Some 
think  that  interest  may  be  charged  to  the  account.  For  instance 
if  money  were  borrowed  at  6%  to  pay  the  expense  of  filling  in, 
the  interest  will  frequently  be  added  to  the  cost  of  improvements. 
It  is  doubtful  if  it  is  good  practice,  in  any  event,  to  add  interest 
to  the  cost  of  land,  for  to  do  so  would  mean  that  the  Balance 
Sheet  of  the  company  who  borrowed  money  to  improve  its  real 
estate  would  show  the  land  to  be  worth  more  than  the  land  on 
the  Balance  Sheet  of  the  company  who  paid  cash  for  similar 
improvements. 

Another  matter  that  frequently  requires  consideration  is 
the  appreciation  of  land.  If  land  is  appraised  at  a  higher  value 
than  cost  price  and  its  value  has  clearly  increased,  is  it  advisable 
to  set  up  the  supposed  increase  on  the  books?  Sound  accounting 
practice  opposes  such  a  procedure.  To  set  up  an  appreciation 
in  value  would  necessitate  crediting  an  income  account  with 
the  increased  value.  Such  an  increase  would  represent  an 
unearned  value  and  it  is  not  likely  that  a  company  would  care 
to  pay  income  and  excess  profits  taxes  on  such  an  extraneous 
profit.  Furthermore,  it  would  certainly  be  unwise  to  distribute 
such  a  profit. 

When  land  is  sold  or  otherwise  disposed  of,  the  account 
should  be  credited  for  the  cost  price  of  the  land  and  not  for  the 
selling  price.  The  profit  or  loss  incident  to  the  sale  or  dispo- 
sition of  land  should  be  shown  by  a  special  nominal  account. 
So  far  as  is  possible  nominal  and  real  accounts  should  be  kept 
distinct.  As  many  nominal  accounts  should  be  opened  as  are 
necessary  to  show  the  income  and  deductions  from  income, 
special  profits  and  special  losses. 

The  Theory  of  the  Buildings  Account.  The  object  of 
this  account  is  to  show  the  cost  of  buildings  on  land  owned  by 
the  business.  The  original  cost  is  not  often  a  matter  of  dispute. 
Buildings  may  be  a  part  of  real  estate  purchased,  in  which  case 
a  separate  value  should  be  placed  on  the  land  and  buildings 
before  they  are  recorded  on  the  books.  The  total  of  this  valuation 
should,  of  course,  be  the  same  as  the  purchase  price  of  the  real 
estate  as  a  whole.  Buildings  may  be  erected  under  contract 
in  which  case  the  contract  price  should  undoubtedly  be  set 
up  as  the  cost.  It  would  make  no  difference  whether  they 
were  constructed  under  a  straight  contract  or  a  "cost  plus" 
contract.  Buildings  may  be  built  by  the  firm  itself.  In  this 
case  the  true  cost  should  be  set  up  on  the  books. 


BUILDINGS  123 

"If  the  construction  is  attended  to  by  the  concern 
itself,  upon  plans  submitted  by  an  architect,  the  cost 
of  the  building  would  include  his  fees,  the  expenses  in- 
curred in  connection  with  permits,  licenses,  etc.,  the  cost 
of  insurance  protection,  the  cost  of  all  material  used,  the 
cost  of  labor  expended  on  the  foundations  as  well  as  on 
the  structures,  the  cost  of  any  outside  labor  which  may 
have  been  required,  the  proportion  of  overhead  expenses 
which  apply  to  the  construction,  the  interest  on  any 
moneys  which  have  been  borrowed  for  construction  pur- 
poses and  used  therefore,  up  to  the  time  when  the  new 
buildings  were  open  for  operation." 

Some  business  men  claim  that  they  should  be  entitled  to 
set  up  on  the  books  the  cost  they  would  have  had  to  pay  an 
outsider  to  construct  the  buildings.  Suppose  a  firm  during  an 
off-season  decides  to  construct  a  building  and  by  doing  so  saves 
a  certain  sum  because  it  was  able  to  construct  the  building  cheaper 
than  they  could  get  an  outsider  to  do  the  work.  Would  it  not 
be  correct  to  charge  the  building  account  with  the  sum  it  would 
have  cost  if  the  contract  had  been  given  to  an  outsider  at  an 
increased  price?  In  this  connection,  note  what  Mr.  Walton  has 
to  say: 

"It  is  sometimes  argued  that  the  corporation  would 
be  entitled  to  charge  its  construction  account  with  the 
same  price  that  it  would  charge  an  outside  customer. 
It  is  claimed  that  the  use  of  its  facilities  in  its  own  work 
would  prevent  its  using  them  for  outside  work  on  which 
it  would  make  a  profit.  It  is  more  doubtful  whether 
any  concern  would  allow  its  own  work  to  interfere  with 
the  taking  of  profitable  outside  contracts. 

"No  profit  can  be  made  except  through  a  sale. 
In  this  case  the  reduced  cost  of  the  construction  results 
in  a  saving  and  not  in  a  profit,  since  there  is  no  sale.  In 
the  end  there  will  be  no  difference  in  the  final  effect  on 
profits,  whichever  method  is  adopted.  If  the  construc- 
tion account  is  charged  with  the  cost  of  the  work  plus  the 
regular  profit,  the  carrying  of  the  building  will  be 
raised  and  the  depreciation  to  be  written  off  against  the 
profits  will  be  correspondingly  increased.  Therefore, 
if  a  profit  is  taken  at  first,  it  will  be  written  off  during 
the  life  of  the  plant,  and  will  not  be  a  permanent  profit 
at  all.  On  the  other  hand,  if  the  work  is  charged  out  at 
cost,  the  annual  depreciation  will  be  less  and  the  saving 
will  be  realized  by  the  smaller  yearly  charge  against 
profits  for  depreciation." 


124  PUBLIC  ACCOUNTING  AND  AUDITING 

THE  LAW  OF  REAL  ESTATE 

Fenneberg  in  his  treatise  on  "Simplified  Law"  defines  real 
property  or  real  estate  as  follows:  "Real  property  or  real 
estate  represents  a  definite  portion  of  land  including  everything 
growing  above  the  ground  as  well  as  all  things  hidden  beneath 
the  surface.  Ownership  extends  to  the  center  of  the  earth  and 
to  the  skies  above.  Since  a  landowner  controls  above  and 
beneath  his  land  he  can  forbid  others  from  flying  over  it  as 
well  as  tunneling  under  it;  in  the  latter  case  the  law  governing 
mining  claims  is  the  single  exception.  Real  estate  is  distin- 
guished from  personal  property  inasmuch  as  it  includes  all 
buildings  and  fixtures  with  utensils  necessary  thereto,  such  as 
fences,  walls,  minerals,  furnaces  and  accessories,  gas  and  water 
pipes,  hat  racks  and  book  cases  built  in  the  walls  or  fastened 
to  the  floor,  keys,  blinds,  screens,  mantle  pieces,  gas  fixtures, 
etc." 

Ownership  of  Real  Estate.  Real  estate  may  be  owned 
outright  or  a  person  may  possess  the  right  to  it  during  his  own 
life  or  that  of  another. 

An  Estate  in  Fee  Simple.  An  estate  in  fee  simple  con- 
stitutes an  absolute  ownership  in  real  estate.  This  ownership 
is  unconditional  and  is  not  hampered  by  restrictions.  We  may 
sell,  lease  or  mortgage  such  real  estate  at  any  time. 

An  Estate  for  Life.  An  estate  for  life  constitutes  posses- 
sion or  the  right  to  the  use  of  real  estate  during  one's  life  or  the 
life  of  another.  It  may  be  limited  to  an  individual  to  hold  for 
the  term  of  his  own  life  or  for  that  of  any  other  person,  or  for 
more  lives  than  one.  One  who  has  an  estate  for  the  life  of 
another  may  transmit  it  to  heirs  or  dispose  of  it  by  will  until 
the  event  happens  that  terminates  the  life  tenancy. 

An  Estate  in  Remainder.  If  an  estate  for  life  comes 
to  an  end,  the  final  ownership  of  the  real  estate  must  either  be 
given  to  another  or  revert  to  the  original  owner  or  his  heirs. 
If  the  estate  is  given  to  another  it  is  known  as  an  estate  in 
remainder. 

An  Estate  in  Reversion.  When  an  estate  for  life  ends 
and  it  reverts  to  the  original  owner  or  his  heirs,  it  is  known  as 
an  estate  in  reversion. 

Obligations  of  a  Holder  of  an  Estate  for  Life.     The 

holder  of  an  estate  for  life  must  make  such  repairs  as  are  necessary 
to  prevent  the  property  from  decaying  or  depreciating  in  value. 
He  is  not  bound  to  make  improvements  or  to  replace  buildings 
destroyed  by  acts  beyond  his  control,  such  as  fire,  flood,  cyclone 


THE  LAW  OF  REAL  ESTATE  125 

and  other  causes,  legally  known  £s  "Acts  of  God."  If  improve- 
ments are  made,  they  cannot  be  in  part  or  whole  charged  to 
the  reversioner.  He  need  not  pay  the  principal  of  any  incum- 
brance,  such  as  a  mortgage,  but  he  is  compelled  to  pay  the 
interest.  He  must  do  nothing  to  waste  the  estate,  such  as 
opening  new  mines  or  cutting  all  the  timber.  He  may  operate 
mines  already  open  and  he  may  cut  a  moderate  amount  of 
timber.  If  he  should  pay  the  principal  of  an  incumbrance  or 
an  indebtedness,  he  becomes  a  creditor  of  the  estate  and  the 
reversioner  must  in  some  manner  equitably  indemnify  the  life 
owner. 

Taxes  on  an  Estate  for  Life.  Life  owners  of  real  estate 
must  pay  the  taxes,  but  in  the  case  of  assessments  for  perma- 
nent improvements,  such  as  the  building  of  streets,  the  laying 
of  sewers  and  similar  benefits  in  which  the  reversioner  would 
be  benefitted,  the  reversioner  must,  of  course,  pay  his  portion 
of  such  assessments. 


INCOME  TAX  PROCEDURE 


Taxes  Constitute  Deductions  from  Income.  (Income 
Tax  Law,  Sec.  214.)  "(a)  That  in  computing  net  income  there 
shall  be  allowed  as  deductions: 

"(3)  Taxes  paid  or  accrued  within  the  taxable  year  imposed 
(a)  by  the  authority  of  the  United  States,  except  income,  war- 
profits  and  excess-profits  taxes;  or  (b)  by  the  authority  of  any 
of  its  possessions,  except  the  amount  of  income,  war-profits 
and  excess  profits  taxes  allowed  as  a  credit  under  section  222; 
or  (c)  by  the  authority  of  any  State  or  Territory,  or  any  county, 
school  district,  municipality,  or  other  taxing  subdivision  of  any 
State  or  Territory,  not  including  those  assessed  against  local 
benefits  of  a  kind  tending  to  increase  the  value  of  the  property 
assessed ;  or  (d)  in  the  case  of  a  citizen  or  resident  of  the  United 
States,  by  the  authority  of  any  foreign  country,  except  the 
amount  of  income,  war-profits  and  excess-profits  taxes  allowed 
as  a  credit  under  section  222;  or  (e)  in  the  case  of  a  nonresident 
alien  individual,  by  the  authority  of  any  foreign  country  (except 
income,  war-profits  and  excess-profits  taxes,  and  taxes  assessed 
against  local  benefits  of  a  kind  tending  to  increase  the  value  of 
the  property  assessed),  upon  property  or  business. 

Assessments  not  Deductible.  (Income  Tax  Primer, 
1919.)  "Taxes  assessed  against  an  individual  on  property 
owned  by  him  to  pay  for  the  paving  of  a  street  contiguous  to 
his  property,  the  construction  of  a  sewer,  sidewalk,  etc.,  or  the 


126  PUBLIC  ACCOUNTING  AND  AUDITING 

construction  of  ditches  to  drain  property  owned  by  him, "can 
not  be  claimed  as  deductions.  In  short,  taxes  as  are  not  general 
in  nature  and  are  levied  on  account  of  some  work  or  privilege, 
the  benefit  of  which  accrues  to  a  limited  number  of  property 
owners,  of  which  the  taxpayer  is  one,  are  not  allowable  de- 
ductions." 

Repairs  on  Real  Estate  Leased  to  a  Tenant  Con- 
stitute Business  Expenses  and  are  Deductible.  (Income 
Tax  Law.  Sec.  214.)  "(a)  That  in  computing  net  income 
there  shall  be  allowed  as  deductions: 

"(i)  All  the  ordinary  and  necessary  expenses  paid  or  incurred 
during  the  taxable  year  in  carrying  on  any  trade  or  business 
including  a  reasonable  allowance  for  salaries  or  other  compen- 
sation for  personal  services  actually  rendered,  and  including 
rentals  or  other  payments  required  to  be  made  as  a  condition 
to  the  continued  use  or  possession,  for  purposes  of  the  trade 
or  business,  of  property  to  which  the  taxpayer  has  not  taken 
or  is  not  taking  title  or  in  which  he  has  no  equity." 

Repairs.  (Art.  103.  Reg.  No.  45,  1918.)  "TheTcost 
of  incidental  repairs  which  neither  materially  add  to  the  value 
of  the  property  nor  appreciably  prolong  its  life,  but  keep  it 
in  an  ordinarily  efficient  operating  condition,  may  be  deducted 
as  expense,  provided  the  plant  or  property  account  is  not  increas- 
ed by  the  amount  of  such  expenditures.  Repairs  in  the  nature 
of  replacements,  to  the  extent  that  they  arrest  deterioration 
and  appreciably  prolong  the  life  of  the  property,  should^be 
charged  against  the  depreciation  reserve." 

Repairs  on  Dwellings  Owned  and  Occupied  not  De- 
ductible. (Income  Tax  Law.  Sec.  215.)  "That  in  computing 
net  income  no  deduction  shall  in  any  case  be  allowed  in  respect 
of — 

"(a)  Personal,  living,  or  family  expenses; 

"(b)  Any  amount  paid  out  for  new  buildings  or  for  per- 
manent improvements  or  betterments  made  to  increase  the 
value  of  any  property  or  estate; 

"(c)  Any  amount  expended  in  restoring  property  or  in 
making  good  the  exhaustion  thereof  for  which  an  allowance 
is  or  has  been  made." 


THEORY  QUESTIONS  127 

A.  THEORY  QUESTIONS 

1.  In  auditing  the  accounts  of  a  corporation,  for  the  first 
year  of  its  existence,  what  records  and  documents  should  be 
examined  in  addition  to  the  books  of  account  and  the  vouchers? 

Inst.  Ex.  1917. 

2.  In  making  an  audit,  should  the  auditor  require  to  see 
the  corporate  minute  book,  and  such  other  purely  corporate 
records  of  a  company?     Give  reasons  for  your  answer. 

C.  P.  A.  Ind. 

3.  What  do  you  understand  by  the  following  terms  and 
give  illustrations  of  each:    Fixed  Assets,  Quick  Assets,  Fixed 
Liabilities,  Current  Liabilities,  Fixed  Charges,  Real  Accounts, 
Nominal  Accounts,  Account  Stated,  Internal  Check? 

C.  P.  A.  Mich. 

4.  A  company  used  its  own  material  and  laborers'  services 
in  the  erection  of  an  addition  to  its  own  plant.    These  additions 
to  Capital  account  were  charged  at  market  prices,  the  profit  on 
the  transaction  being  absorbed  in  current  trading  profits.     Do 
you  consider  this  method  correct?    Explain  fully  the  principles 
involved.  C.  P.  A.  Nebr. 

5.  A  concern  needs  an  addition  to  its  plant.     Not  having 
enough  ready  capital,  they  borrowed  money  and  when  the  in- 
terest was  paid  it  was  charged  to  the  "Plant"  account  on  the 
theory  that  it  was  not  an  expense  in  the  ordinary  conduct  of 
the  business  and  should,  therefore,  not  be  charged  to  the  regular 
Interest  and   Discount  account  but  might  with  propriety  be 
charged  as  a  part  of  the  cost  of  the  addition.      Is  the  theory 
sound?  C.  P.  A.  Mich. 

6.  A  company  purchased  land  and  on  this  land  was  a  build- 
ing which  the  company  had  to  pull  down  in  order  to  make  the 
required  use  of  the  land.     During  the  demolishing  of  the  build- 
ing, a  workman  was  killed.    To  what  account  should  the  com- 
pensation in  respect  of  this  accident  be  charged  and  why? 

C.  P.  A.  Pa. 

B.  ACCOUNTING  PROBLEMS 

i.  You  are  employed  to  prepare  a  statement  for  credit 
purposes  from  figures  submitted  to  you  in  a  letter  from  the 
Western  Manufacturing  Company.  Their  letter  submits  figures 
and  data  as  follows: 

Their  plants  stand  at  cost  price,  $90,600.00.  They  have  set 
up  a  reserve  for  depreciation  of  $15,300.00.  There  is  a  mortgage 
of  $30,000.00  on  the  plant  and  interest  on  the  mortgage  is  at 
6%  and  is  paid  to  within  three  months  of  date  of  your  proposed 
statement.  They  hold  $15,000.00  of  notes  receivable  and  have 
discounted  at  bank  $37,500.00.  Accounts  receivable  they  con- 


128  PUBLIC  ACCOUNTING  AND  AUDITING 

sider  good,  amount  $27,000.00,  including  $4,500.00  due  from 
employee  on  personal  account.  Accounts  with  trade  customers 
are  subject  to  5%  discount  if  paid  at  due  date,  and  $15,000.00 
is  now  past  due.  Suspense  accounts  amount  to  $6,000.00, 
50%  of  which  are  believed  to  be  good.  A  new  machine  has 
been  ordered  but  not  yet  delivered,  which  cost  $9,000.00.  They 
have  endorsed  a  note  for  $9,000.00  for  Smith  and  Co.,  but  say 
it  will  be  paid  when  due.  Accounts  payable  amount  to  $63,000.00, 
insurance  amounts  to  $600  a  year  and  has  six  months  to  run. 
They  owe  a  note  at  bank  for  $7,500.00,  interest  paid  to  date. 
They  own  50  shares  of  stock  in  a  company  from  whom  they 
buy  raw  materials.  They  cost  $4,200.00,  and  are  presumed 
to  be  worthless.  Inventory  was  taken  at  a  selling  price  of  10% 
more  than  cost.  This  amounts  to  $26,400.00. 

You  are  not  asked  to  accept  any  responsibility  for  the 
figures  in  the  statement  but  simply  to  prepare  the  statement 
in  the  best  form  you  can  from  their  letter.  C.  P.  A.  Ind. 

2.     A  company  is  formed  under  the  laws  of  Mexico,  to 

take  over  and  work  certain   mining  properties.     At  the  end 

of  one  year  the  company  is  found  to  possess: 

Mining  lands $  484,675.48 

Buildings  and  Improvements 20,409.76 

Machinery 25,612.88 

Cash  on  hand  and  in  bank 24,612.50 

Silver  Bullion 85,209.50 

Ore  in  dump 13,680.00 

Merchandise 5,420.80 

Fuel,  oil,  etc 679.20 

The  company  owes: 

On  open  accounts 3,890.12 

On  account  of  pay-rolls 400.00 

Note  due  in  six  months  with  int.  6% 25,000.00 

Capital  Stock  (Fully  paid)  is 500,000.00 

Set  up  Balance  Sheet.  C.  P.  A.  Mich. 


C.     INCOME  TAX  QUESTION 

You  own  two  houses,  in  one  of  which  you  live.  The  other 
is  leased  to  a  tenant  at  a  fixed  monthly  rental.  You  paid  during 
1918  real  estate  taxes  to  the  state,  county,  city  or  township  on 
both  properties.  You  also  paid  for  the  repairs  on  both. 

(a)  Does  the  present  federal  income  tax  law  make  any 
distinction  between  the  two  properties  as  to  these  two  classes 
of  expenses? 

(b)  If  so,  explain  the  reason,  if  any,  for  the  distinction. 

Inst.  Ex.  1919. 


Chapter  Nine 


FIXED  ASSETS  (Continued) 

Capital  and  Revenue  Expenditures.  Buildings  are  also 
subject,  after  construction  or  purchase,  to  improvement,  bet- 
terment, repair,  renewal,  replacement,  alteration,  depreciation, 
assessment,  and  destruction.  All  subsequent  charges,  after  the 
cost  has  been  recorded,  raise  the  question  of  the  proper  separa- 
tion of  capital  expenditures  and  revenue  expenditures. 

Briefly,  capital  expenditures  might  be  defined  as,  all  sums 
expended  for  addition  to,  or  improvement  of  properties.  The 
American  Encyclopedia  defines  revenue  expenditures  as,  "expen- 
ditures made  in  connection  with  the  running  expenses  of  the 
legitimate  business  of  the  firm  or  corporation  concerned." 

Capital  expenditures  may  be  charged  to  the  asset  accounts 
affected  while  revenue  expenditures  should  be  charged  to  the 
proper  expense  account.  Lawrence  R.  Dicksee*  says,  "If  an 
expenditure  has  only  had  the  effect  of  putting  the  earning  power 
of  the  undertaking  upon  the  same  footing  as  that  which  had 
previously  obtained,  it  must  be  charged  to  revenue." 

In  summing  up,  the  auditor  should  analyze  the  accounts 
with  fixed  assets,  and  if  he  finds  any  items  that  he  is  in  doubt 
about  they  should  be  noted  and  carefully  investigated.  Improve- 
ments that  increase  the  earning  capacity  of  the  plant  and  that  are 
not  of  the  nature  of  either  renewals  or  improvements,  may  be  cap- 
italized. All  other  expenditures  in  the  nature  of  upkeep  and  repairs 
should  be  charged  to  an  expense  account.  Some  bookkeepers, 
when  in  doubt  as  to  whether  an  expenditure  constitutes  an  actual 
improvement,  charge  it  to  the  asset  account  anyway.  Their  rea- 
son for  so  doing  is  that  if  it  is  later  found  that  the  item  should 
have  been  charged  to  expense,  it  may  be  adjusted  without 
much  difficulty,  while  on  the  other  hand,  an  item  charged  to  ex- 
pense, but  which  should  have  been  charged  to  the  asset  account, 
is  always  difficult  to  adjust  because  it  is  usually  necessary  to  make 
explanations  and  secure  authority  for  the  adjustment.  It  is 
more  conservative,  however,  to  overcharge  the  revenue  expendi- 
tures than  to  overcharge  the  capital  expenditures.  So  far  as 
possible,  adjustments  should  be  avoided  except  when  absolutely 
necessary. 

*Of  the  firm  of  Price  &  Dicksee. 

129 


130  PUBLIC  ACCOUNTING  AND  AUDITING 

The  Theory  of  the  Machinery  Account.  The  object  of 
this  account  is  to  show  the  cost  of  machinery  on  hand  and  in 
use  in  the  factory.  Separate  accounts  may  be  kept  with  different 
classes  of  machinery.  For  instance,  one  account  might  be  kept 
with  Universal  machines  and  another  with  Special  machines. 
By  Universal  machines  is  meant  standard  or  stock  machines 
that  may  be  purchased  from  manufacturers  whose  business  it  is 
to  manufacture  such  machines.  They  are  built  and  carried  in 
stock  for  sale.  By  Special  machines  is  meant  those  specially 
designed  and  built  either  by  the  concern  itself  or  by  another 
under  contract  according  to  specifications.  The  usual  practice, 
however,  is  to  maintain  but  one  account  with  Machinery.  It  is 
frequently  combined  with  tools,  implements,  and  other  items, 
but  this  is  poor  practice  and  is  not  to  be  encouraged. 

The  account  with  Machinery  should  show  on  the  debit 
side;  (a)  the  cost  of  machinery  on  hand  at  the  beginning  of  the 
business;  (If  the  machinery  is  part  of  a  plant  that  has  been 
purchased  or  otherwise  acquired,  for  a  purchase  price  covering 
the  entire  plant,  it  may  be  necessary  to  estimate  the  value  of 
each  part  of  the  plant  subdivided  into  accounts.  Furthermore, 
the  book  value  set  up  may  not  be  the  actual  inventory  or  ap- 
praisal value,  but  the  difference  between  the  asset  account  and 
the  reserve  for  depreciation  account,  applicable  thereto,  should 
represent  the  actual  value,  provided  sufficient  reserve  for  de- 
preciation has  been  set  up.)  (b)  the  cost  of  machinery  and  equip- 
ment purchased  or  manufactured  by  the  concern  itself  after 
operations  have  begun;  (c)  the  cost  of  additions  or  alterations 
which  actually  increase  the  value  and  efficiency  of  the  machinery 
already  in  use;  (This  must  not  be  construed  to  include  altera- 
tions made  necessary  by  a  mere  change  in  product,  nor  to  in- 
clude the  cost  of  moving  and  reinstalling  machines  to  permit  of 
more  economical  operation.  In  such  cases,  if  the  cost  is  large, 
it  may  be  advisable  to  treat  it  as  a  deferred  expense  and  to  be 
charged  off  over  a  period  of  years  or  during  the  years  to  be  bene- 
fited by  the  changes  made.)  and  (d)  the  cost  of  new  parts  pur- 
chased. 

With  regard  to  the  last  item,  a  great  deal  will  depend  on  the 
policy  of  the  firm  concerning  the  method  used  in  arriving  at  the 
proper  amount  of  depreciation  to  be  charged  off.  If  the  cost  of 
all  new  parts  which  are  to  replace  old  parts  is  charged  to  op- 
erating expense,  the  rate  of  depreciation  will  be  lower,  other- 
wise, the  rate  should  be  higher.  If  the  cost  of  new  parts  is 
charged  to  the  Machinery  account,  then  the  cost  of  the  worn 
parts  being  replaced  should  be  credited  to  the  Machinery  ac- 
count and  at  the  same  time  charged  to  reserve  account,  because 
the  rate  of  depreciation  charged  off  to  operating  expense  has 
been  sufficiently  high  to  include  the  wear  of  such  parts.  After 
a  part  has  been  replaced  with  a  new  part  no  further  reserve  for 
depreciation  on  that  particular  part  is  necessary,  hence  it  should 
be  charged  to  the  reserve  account.  Another  argument  in  favor 


of  charging  new  parts  to  the  Machinery  account  is  their  cost 
may  be  higher  or  lower  than  the  original  parts,  and  if  the  cost 
of  the  old  parts  being  replaced  is  credited  to  the  account  and  the 
new  parts  charged  to  the  account,  the  Machinery  account  will  at 
all  times  represent  the  actual  cost  of  machinery  in  operation. 

Any  machines  or  machine  parts  exchanged,  discarded,  de- 
stroyed, or  otherwise  disposed  of,  should  be  credited  to  the  Ma- 
chinery account  and  charged  to  the  reserve  account  at  cost  price. 

In  the  case  of  machinery  built  or  manufactured  by  the  con- 
cern itself,  the  cost  should  include  the  cost  of  material  and  labor, 
plus  the  freight  and  cartage  inward  and  a  proper  proportion  of 
overhead  expenses.  It  is  customary  to  add,  also,  the  cost  of  the 
experiments,  which  were  made  before  a  desirable  type  was  ob- 
tained, plus  the  cost  of  the  designs  and  patterns. 

The  cost  of  installing  new  machinery,  such  as  the  building 
of  foundations,  connecting  it  \vith  the  transmission,  moving  it 
into  place,  etc.,  is  a  part  of  the  cost  of  the  machinery  and  should 
be  charged  to  the  Machinery  account.  In  other  words,  the  Ma- 
chinery account  should  show  the  actual  cost  of  machinery  when 
it  is  ready  for  operation. 

Montgomery  says: 

"The  cost  of  installation,  including  freight,  labor,  and  other 
items  is  as  much  a  part  of  the  cost  as  the  price  of  the  machinery 
itself." 

Cox*  says: 

"The  entire  cost  of  installing  new  machines  constitutes  an 
addition  and  should  be  capitalized." 

Walton  says: 

"The  purchase  price,  the  freight,  the  cost  of  moving  an  old 
machine  to  make  way  for  a  new  one  and  the  cost  of  installing 
a  new  machine  are  proper  charges  to  the  Machinery  account." 

It  is  not  considered  good  accounting  practice  to  add  interest 
on  borrowed  money  used  to  purchase  or  construct  machinery 
or  in  the  installation  process.  If  this  were  done  the  firm  who 
borrowed  money  with  which  to  construct  machinery  or  to  pay 
the  cost  of  installation,  would  show  the  asset  at  a  higher  value 
than  the  firm  who  did  not  need  to  borrow  the  money. 

The  Theory  of  the  Tools  and  Implements  Account. 

The  object  of  this  account  is  to  show  the  value  of  small  tools  on 
hand.  There  are  several  different  methods  for  recording  the 
value  of  tools.  It  is  always  best,  if  the  value  of  tools  on  hand 
is  to  be  considered  a  fixed  asset,  to  take  a  physical  inventory  at 
the  end  of  the  period  under  audit  before  preparing  the  state- 
ments. Tools  are  so  often  lost,  misplaced,  or  stolen  and  they 
are  used  up  so  rapidly  that  it  is  difficult  to  determine  their 
actual  value  in  any  other  manner. 


""'Classified  C.  P.  A.  Problems  and  Solutions." 


132  PUBLIC  ACCOUNTING  AND  AUDITING 

One  method  is  to  charge  the  Tools  and  Implements  account 
with  the  cost  of  all  tools  purchased  and  at  the  end  of  the  year 
to  take  a  physical  inventory  and  make  an  adjusting  entry  credit- 
ing the  asset  account  with  the  cost  value  of  all  tools  used  up  or 
missing  and  charging  the  proper  operating  expense  account.  If 
this  is  done,  no  reserve  for  depreciation  need  be  set  up. 

Another  method  is  to  charge  the  account  with  tools  as 
above,  but  to  issue  all  tools  to  the  workmen  and  at  certain  times 
require  them  to  submit  all  tools  for  inspection.  At  this  time  all 
tools  worn  out,  broken,  or  worthless  are  charged  to  expense  and 
new  tools  issued  to  the  workmen.  Any  tools  missing  or  other- 
wise unaccounted  for  are  charged  to  the  workmen  and  deducted 
from  their  wages.  In  either  case  the  account  with  tools  would 
be  credited  with  the  cost  price  of  the  tools  worn  out,  broken, 
worthless,  or  missing  and  the  balance  of  the  account  would  show 
the  cost  of  tools  on  hand  and  in  use.  No  reserve  for  deprecia- 
tion is  necessary,  but  it  is  necessary  to  require  the  workmen  to 
submit  all  tools  for  inspection  before  preparing  the  statements. 
At  this  time  the  account  would  be  adjusted. 

A  third  method  is  to  charge  all  tools  and  implements  to 
operating  expense  at  the  time  of  their  purchase,  and  if  there  are 
any  new  tools  on  hand  at  the  end  of  the  fiscal  period,  their  value 
at  cost  price  is  treated  as  a  deferred  expense.  This  method  sim- 
ply necessitates  an  inventory  of  new  tools  on  hand  undistributed. 

Montgomery  says: 

"As  a  rule,  the  practice  of  depreciating  small  tools  by  way 
of  a  percentage  cannot  be  followed  satisfactorily.  So  many 
small  tools  are  used  up,  or  lost,  or  stolen,  that  an  inventory 
should  be  made  periodically  and  all  tools  on  hand  revalued.  If 
this  plan  is  followed  for  several  years  and  a  dependable  rate  of 
depreciation  is  secured,  it  may  be  feasible  to  omit  the  revalua- 
tion for  a  year  or  two,  applying  the  rate  previously  ascertained." 

The  Tax  Commissioner  of  one  of  the  states  has  adopted 
rates  varying  from  25  to  50  per  cent,  or  as  an  alternative  the 
entire  cost  of  replacements. 

Esquerre'  says: 

"The  tools  contained  in  this  account  are  sometimes  re- 
ferred to  as  'small  equipment.'  They  comprise,  saws,  files, 
hammers,  screwdrivers,  etc.,  which  on  account  of  their  fragility, 
their  size,  the  manifold  uses  to  which  they  are  placed,  and  the 
facility  with  which  they  can  be  passed  from  hand  to  hand  and 
from  bench  to  bench,  cannot  be  readily  or  accurately  inven- 
toried. They  are  generally  kept  under  the  custody  of  a  store- 
keeper and  charged  to  cost  of  manufacture  when  issued  to  the 
factory." 

Greendlinger*  says: 

"Tools  which  are  fixed  and  which  in  reality  enter  into  the 
same  category  as  machinery,  should  be  valued  in  the  same  man- 

*Author  of  "Accountancy  Problems  with  Solutions." 


HORSES,  WAGONS  AND  HARNESS  133 

ner.  Small  tools,  however,  unless  the  aggregate  is  large,  should 
be  considered  expenses.  Where  there  are  a  great  many  it  would 
be  better  to  consider  them  as  supplies  and  so  list  them  in  the 
inventory." 

The  Theory  of  the  Account  with  Horses,  Wagons  and 
Harness.  This  account  is  rapidly  being  replaced  with  accounts 
with  Auto  Trucks  or  motorized  delivery  equipment.  However, 
the  theory  of  the  account  is  the  same.  The  items  charged  to  it 
represent  delivery  equipment.  The  only  difference  is  the  amount 
of  depreciation  to  be  charged  off  or  set  up. 

Some  firms  charge  the  account  with  the  original  cost  and 
then  charge  all  replacements  and  additions  to  expense.  This  is 
hardly  to  be  commended  because  it  does  not  show  true  facts  at 
the  end  of  the  period.  If  the  original  value  is  increased  or  de- 
creased by  a  conservative  inventory  or  appraisement  before  pre- 
paring the  statements,  the  difficulty  may  be  overcome  to  some 
extent. 

A  better  practice  would  be  to  charge  the  account  with  the 
cost  of  all  delivery  equipment  and  then  set  up  a  reserve  for 
depreciation  that  is  estimated  to  be  equal  to  the  reduction  in  the 
value  of  the  property.  Under  this  plan,  if  losses  occur  by  reason 
of  accidents  or  other  causes,  the  account  is  credited  with  the 
original  cost.  If  the  account  had  been  credited  direct  with  the 
amount  of  the  estimated  depreciation,  then  only  the  depreciated 
value  would  be  credited  to  the  account  at  the  time  of  loss.  It 
is  advisable  to  set  up  special  reserve  accounts  for  each  property 
account  subject  to  depreciation.  (Depreciation  will  be  taken 
up  in  the  Tenth  Chapter  and  will  be  discussed  in  detail.) 

The  Federal  Trade  Commission,  in  a  bulletin  issued  July  15, 
1916,  entitled  "A  System  of  Accounts  for  Retail  Merchants,/ 
says,  "Charge  the  account  with  Delivery  Equipment  with  the 
cost  of  automobiles,  wagons,  horses,  and  harness.  This  account 
must  not  be  charged  with  repairs  to  automobiles  and  wagons, 
horseshoeing  or  anything  of  this  nature.  A  fair  amount  should 
be  written  off  periodically  for  depreciation." 

The  Theory  of  the  Office  Furniture  Account.  In  prac- 
tice different  methods  will  be  found  to  exist  in  recording  the 
value  of  office  furniture  or  equipment.  It  will  depend  upon  the 
policy  of  the  concern.  In  many  instances  the  account  will  in- 
clude fixtures,  partitions,  etc.  What  was  said  with  reference  to 
the  account  with  delivery  equipment  is  applicable  here.  The 
important  thing  is  to  be  conservative.  If  the  account  is  charged 
with  the  cost  of  all  office  furniture  purchased  and  a  reserve  ac- 
count is  set  up  crediting  it  with  the  estimated  amount  of  the 
depreciation  each  year,  it  will  represent  sound  accounting  prac- 
tice. 


134  PUBLIC  ACCOUNTING  AND  AUDITING 

The  Federal  Trade  Commission  says  in  regard  to  the  ac- 
count with  Office  Furniture,  "Charge  this  account  with  office 
furniture,  desks,  safe,  and  other  office  appliances.  It  should  not 
be  charged  with  the  cost  of  typewriter  supplies,  account  books, 
etc.,  as  these  are  clearly  items  of  expense.  A  fair  amount 
should  be  written  off  periodically  for  depreciation." 

AUDITING  THEORY 

Quoting  from  Federal  Reserve  Bulletin: 

Schedules.  "In  preparing  the  leading  schedules  for  the 
accounts  grouped  under  this  heading,  such  as  real  estate,  build- 
ings, plant,  machinery,  etc.,  the  balances  at  the  beginning  of 
the  period,  the  additions  to  or  deductions  from  the  accounts 
during  the  year,  and  the  balances  at  the  end  of  the  period  must 
be  shown. 

"The  total  of  the  balances  at  the  beginning  of  the  period 
must  agree  with  the  cost  of  property  figures  given  in  the  Balance 
Sheet  at  that  date,  and  the  balances  at  the  end  of  the  period 
with  the  amount  shown  in  the  Balance  Sheet  that  is  being 
audited.  The  charges  entering  into  the  additions  must  be  veri- 
fied in  detail,  and  in  this  connection  the  following  notes  are  of 
value  : 

Authorizations  for  Expenditures,  (i)  "Authorizations 
for  the  expenditures  made  during  the  year  should  be  examined, 
and  where  the  costs  of  the  additions  have  overrun  the  sums  au- 
thorized, inquiries  should  be  made  in  regard  thereto.  The 
authorizations  should  show  the  accounts  to  which  the  expendi- 
tures are  chargeable,  the  amounts  thereof,  the  approvals  of  the 
comptroller  and  manager,  and  descriptions  of  the  jobs.  When 
the  authorizations  are  not  specific  as  to  the  work  done,  the 
actual  additions  should,  if  possible,  be  inspected. 

Additions.  (2)  "The  auditor  should  satisfy  himself  before 
approving  additions  that  they  were  made  with  the  object  of 
increasing  the  earning  capacity  of  the  plant,  and  that  they  are 
not  of  the  nature  of  either  renewals  or  improvements,  and  in  this 
connection  changes  in  the  production  and  capacity  of  the  plant 
should  receive  consideration. 

Pay  Roll  and  Store  and  Supply  Charges.     (3)   "To 

verify  the  pay  roll  and  store  and  supply  charges  to  jobs,  one  or 
two  pay  roll  distribution  reports  should  be  examined  in  detail, 
and  also  one  or  two  storehouse  reports.  In  cases  where  large 
purchases  have  been  made  from  outside  parties  for  capital 
construction  work,  the  vouchers  therefor  should  be  examined 
and  the  usual  precautions  taken  to  see  that  they  are  properly 
approved  for  the  the  receipt  of  materials,  prices,  etc. 


FIXED  ASSETS  135 

Real  Estate  Purchases.  (4)  "For  purchases  of  real  estate 
the  title  deeds  should  be  examined,  together  with  the  vouchers, 
and  it  should  be  seen  that  the  deeds  have  been  properly  recorded. 

Factory  Overhead  Cost.  (5)  "While  it  may  be  consid- 
ered permissible  to  make  a  charge  for  factory  overhead  cost  to 
additions  to  property  such  as,  e.  g.,  time  of  superintendent  and 
his  clerical  force  employed  on  construction  work,  etc.,  it  cannot 
be  deemed  conservative  business  practice,  inasmuch  as  the 
probabilities  are  that  the  overhead  charges  of  a  plant  will  not  be 
decreased  to  any  extent  even  though  additions  are  not  under 
way,  and,  therefore,  the  absorption  of  part  of  these  charges 
when  additions  are  in  progress,  has  the  effect  of  reducing  the 
operating  costs,  as  compared  with  months  in  which  no  construc- 
tion work  is  under  way. 

Construction  Work  in  Progress.  (6)  "Construction 
work  in  progress  at  the  end  of  the  fiscal  period  should  be  shown 
in  the  Balance  Sheet  under  the  heading  of  fixed  assets  and  not 
as  part  of  the  inventories.  This  is  important  to  bear  in  mind 
because  construction  work  is  not  an  asset  that  can  be  quickly 
turned  into  money,  while  everything  in  the  inventory  is  sup- 
posed to  be  realizable  in  cash  within  a  reasonable  short  time. 

Installments  on  Construction  Work.  (7)  "The  auditor 
should  inquire  as  to  whether  any  installments  are  due  on  ac- 
count of  construction  work  in  progress  which  is  being  carried 
on  by  outside  parties;  and  if  so,  the  liabilities  for  these  install- 
ments should  be  included  in  the  Balance  Sheet,  as  they  may 
have  a  direct  bearing  on  the  amount  of  available  cash  on  hand. 

Leases.  (8)  "When  a  company  uses  leasehold  properties 
the  leases  should  be  examined  and  notes  made  of  the  periods 
covered,  so  that  it  may  be  seen  that  improvements,  etc.,  on  such 
properties  are  written  off  over  the  periods  covered  by  the  leases. 

Reserves  for  Depreciation.  (9)  "The  auditor  should 
satisfy  himself  that  the  reserves  for  depreciation  of  buildings, 
machinery,  equipment,  etc.,  are  adequate  to  reflect  the  deteri- 
oration in  the  value  of  the  fixed  properties.  If  in  his  opinion 
the  reserves  shown  on  the  Balance  Sheet  are  insufficient,  he 
should  call  attention  to  the  matter  in  his  certificate. 

Property  Destroyed  by  Fire.  (10)  "Care  should  be 
taken  to  insure  that  property  destroyed  by  fire  or  othenvise 
prematurely  put  out  of  service  is  correctly  treated  in  the  books. 
Any  portion  of  the  original  charge  for  such  property  which  is 
not  recoverable  through  insurance,  as  salvage  or  otherwise, 
and  has  not  been  provided  for  by  the  depreciation  scheme 
should  be  written  off. 

"It  is  to  be  observed  that  the  foregoing  notes  are  to  be 
applied  only  to  cost  of  properties  incurred  during  the  period 


136  PUBLIC  ACCOUNTING  AND  AUDITING 

under  audit.  In  addition,  information  may  usually  be  ob- 
tained on  broader  lines  in  regard  to  the  composition  of  the  Real 
Estate,  Building,  and  Machinery  accounts,  and  showing  what 
principal  property  is  represented  thereby  and  how  the  accounts 
have  been  built  up  from  year  to  year  for  a  reasonable  time  past 
if  not  from  the  inception  of  the  business.  The  information  de- 
rived therefrom  is  valuable  only  in  indicating  the  progressive 
policy  of  the  concern,  the  extent  to  which  it  reinvests  undivided 
surplus  in  its  plan,  etc.  Beyond  these  facts  the  banker  who  is 
asked  for  ordinary  discounts  or  short-term  loans  is  not  in- 
terested; he  looks  more  to  the  quick  assets  for  his  security. 

When  an  Appraisement  is  Necessary.  "Optional.— 
When  the  loan  is  greater  than  the  quick  assets  seem  to  justify 
the  auditor  should  suggest  a  reliable  verification  of  the  cost  of 
property  prior  to  the  period  under  audit.  Such  action  may 
become  necessary  even  to  the  extent  of  calling  for  an  appraise- 
ment by  disinterested  outside  experts." 


AUDITING  PROCEDURE 

Analyzing  Fixed  Assets.  J.  I.  King,  junior  accountant, 
made  an  analysis  of  the  fixed  asset  accounts.  Inasmuch  as  all 
account  footings  had  been  carefully  verified  when  the  Trial 
Balance  was  vouched,  it  was  only  necessary  to  determine  whether 
all  charges  to  the  asset  accounts  represented  actual  capital  dis- 
bursements and  that  adequate  reserves  for  depreciation  had 
been  set  up. 

The  Land  Account.  The  amount  charged  to  this  account, 
$100,000.00,  represents  the  actual  cost  of  the  land  at  the  time 
of  its  purchase.  The  deed  was  examined  and  found  to  be  proper- 
ly recorded. 

The  Buildings  Account.  Building  operations  were  begun 
immediately  after  the  purchase  of  the  land  and  the  book  value 
as  set  up  represents  the  actual  contract  price  of  the  buildings 
when  completed.  A  reserve  for  depreciation  amounting  to 
2^2%  has  been  set  up  annually.  The  Buildings  account  shows 
a  debit  of  $150,000.00,  and  the  Reserve  for  Depreciation  on 
Buildings  account  shows  a  credit  of  $2,500.00.  The  buildings 
were  completed  May  i,  1917,  and  the  Reserve,  at  the  end  of 
the  year,  was  credited  for  depreciation  on  the  basis  of  ^  of  a 
year. 

A  question  might  arise  as  to  whether  this  represents  a 
proper  percentage  of  depreciation.  Inasmuch  as  the  buildings 
are  of  concrete  and  brick  construction,  it  is  considered  adequate. 
(See  discussion  of  Depreciation,  Chapter  Ten.) 


FIXED  ASSETS  137 

The  Machinery  Account.  The  book  value  amounting 
to  $100,000.00  represents  the  original  cost  price  of  all  machinery, 
including  installation.  An  item  amounting  to  $215.00  was 
found  to  have  been  posted  to  Tools  and  Implements,  but  it 
should  have  been  charged  to  the  Machinery  account,  as  it  rep- 
resented the  cost  of  a  new  machine.  A  reserve  for  depreciation 
amounting  to  6%  has  been  set  up  annually. 

After  the  Machinery  account  was  adjusted  it  showed  a 
debit  footing  of  $100,215.00.  The  Reserve  for  Depreciation  of 
Machinery  account  shows  a  credit  of  $9,000.00.  The  original 
Machinery  was  purchased  July  I,  1916.  A  new  machine  costing 
$215.00  was  purchased  July  I,  1918. 

Tools  and  Implements  Account.  This  account  shows 
a  debit  balance  of  $20,215.00.  $215.00  charged  to  this  account 
represents  'an  addition  to  machinery  and  was  posted  to  this 
account  through  'an  error.  It  was  adjusted.  No  reserve  for 
depreciation  account  was  set  up.  The  practice  has  been  to  credit 
the  account  direct  with  the  amount  of  the  estimated  deprecia- 
tion which  was  arrived  at  after  a  physical  inventory.  On  De- 
cember 31,  1918,  a  physical  inventory  was  taken  under  the 
supervision  of  the  different  foremen.  Further  investigation 
shows  that  the  balance  of  the  account  represents  the  actual  cost 
value  of  all  tools  considered  new  or  unworn  at  that  date  and 
either  in  the  hands  of  the  workmen  or  undistributed.  On  De- 
cember 10,  1918,  there  had  been  purchased  $5,250.00  worth  of 
new  tools  that  had  not  yet  been  distributed.  The  amount,  at 
cost  price,  of  tools  used  up  during  the  year  had  been  charged  to 
operating  expense. 

Horses,  Wagons  and  Harness  Account.  The  balance 
of  this  account  shows  a  debit  of  $15,000.00.  The  practice  has 
been  to  charge  the  cost  of  horses,  wagons,  and  harness  purchased 
to  the  account.  The  account  is  credited  with  the  cost  price  of 
any  items  sold,  exchanged,  destroyed  or  discarded.  The  Reserve 
for  Depreciation  account  shows  a  balance  on  the  credit  side  of 
$1,500.00.  This  account  is  credited  annually  with  10%  of  the 
cost  as  shown  by  the  account  at  the  beginning  of  the  year. 
The  equipment  was  purchased  January  1, 1917,  and  no  additions 
have  been  made  since  that  time. 

Office  Furniture  Account.  This  account  was  found  to 
show  a  debit  balance  of  $2,600.50.  No  reserve  for  depreciation 
has  been  set  up,  the  practice  being  to  credit  the  account  annu- 
ally with  the  estimated  amount  of  depreciation.  The  deprecia- 
tion has  been  calculated  at  10%. 

Book  Variations.  Montgomery  says:  "Where  an  auditor 
cannot  secure  reliable  information  with  respect  to  plant  valuations 


138  PUBLIC  ACCOUNTING  AND  AUDITING 

he  should  state  in  his  report  that  real  estate,  machinery,  and 
similar  assets  are  stated  at  book  valuations.  He  should ,  however, 
attempt  to  ascertain  whether  these  book  valuations  honestly  re- 
flect present  conditions.  His  services  are  of  little  real  value  if 
such  items  are  grossly  overvalued  and  a  net  worth  is  shown 
which  should  be  corrected  by  an  intelligent  use  of  evidence  easily 
available  by  the  auditor. 

"The  auditor  is  charged  with  the  duty  of  attempting  to 
analyze  the  fixed  assets  as  shown  by  the  books  to  ascertain  the 
principles  upon  which  they  have  been  created." 

THE  LAW  OF  PERSONAL  PROPERTY 

It  is  appropriate  that  we  discuss  the  law  in  its  relation  to 
property  at  the  same  time  we  discuss  fixed  assets.  Fixed  assets, 
as  has  already  been  made  clear,  are  to  be  classed  among  the 
real  accounts.  There  is  a  distinction,  however,  between  real 
accounts  and  real  property.  Real  property  has  already  been 
defined  in  the  preceding  chapter.  Real  property,  including 
land,  buildings,  etc.,  is  a  fixed  asset  unless  it  represents  the 
stock-in-trade  of  the  concern.  Naturally,  if  one's  business  is 
that  of  a  dealer  in  real  estate,  such  real  estate  becomes  a  current 
asset  the  same  as  any  other  stock-in-trade. 

Personal  property,  however,  may  represent  either  a  current 
or  a  fixed  asset,  for  it  includes  both  the  stock-in-trade  and  all 
equipment  which  cannot  be  classed  as  real  property.  It  will 
be  seen  from  the  above  distinction  that  it  is  important  that 
the  accountant  be  able  to  distinguish  between  real  and  personal 
property.  We  can  do  no  better  than  to  quote  from  Peters' 
Commercial  Law*  with  regard  to  the  kinds  of  property. 

"Personal  property  is  movable  in  its  nature,  and  includes 
every  particular  sort  of  property  not  possessing  the  nature  of 
real  property,  such  as  promissory  notes,  merchandise,  crops, 
furniture,  mortgages,  books,  stocks  and  bonds,  animals,  patents, 
manufactured  goods,  and  the  like.  Personal  property  may  be 
changed  into  real  property,  as  where  one  takes  brick  and  mortar — 
all  personal  property —  and  constructs  a  house  with  them  which 
is  then  considered  real  property;  and  if  in  the  lapse  of  time 
that  same  house  be  razed  to  the  ground  and  the  building  ma- 
terial sold  as  such  they  again  acquire  the  characteristics  of 
personal  property. 

Chattels.  "The  name  'chattel'  is  frequently  applied  to 
personal  property  and  is  the  term  usually  employed  at  the 
common  law  to  denote  personal  property  in  general.  It  is  a 
more  extensive  term  than  goods  or  effects  and  includes  every 
kind  of  property  except  property  in  land.  Its  meaning  is  com- 

*By  P.  B.  S.  Peters,  LL.  B.  Published  by  South-Western  Publishing 
Company. 


THE  LAW  OF  PERSONAL  PROPERTY  139 

monly  confined  to  things  movable  in  their  character,  as  animals, 
machinery,  grain,  or  any  article  that  can  be  handled  and  trans- 
ported. 

Ways  of  Acquiring  Title  to  Personal  Property.  "The 
two  general  ways  in  which  title  to  personal  property  may  be 
obtained  are:  (i)  by  original  acquisition;  (2)  by  transfer. 

(i)  Acquisition.  "Under  original  acquisition  the  first 
general  method  of  acquiring  title  is  by  occupancy.  This  is 
brought  about  by  taking  into  one's  possession  what  previously 
belonged  to  no  other  person,  or  what  was  abandoned  by  a  prior 
owner. 

"Wild  animals  belong  to  no  one  in  particular  until  they 
are  captured.  Whoever  captures  such  an  animal  has  the  ex- 
clusive right  to  it  while  in  his  possession,  or  until  it  has  become 
so  far  domesticated  that  it  has  the  habit  of  returning  after 
wandering  at  large.  If,  however,  it  escapes  and  regains  its 
natural  freedom  any  other  person  may  rightfully  take  it  who 
captures  or  kills  it.  A  mere  temporary  escape,  as  where  a  lion 
escapes  from  its  cage,  may  not  amount  to  regaining  its  natural 
liberty. 

"The  finder  acquires  title  to  personal  property  abandoned 
by  the  owner  of  property  that  has  been  lost  but  never  re- 
claimed. But  the  former  owner  must  have  completely  relin- 
quished his  ownership  intending  to  give  up  all  his  rights  in  it 
before  a  perfect  title  will  accrue  to  the  finder. 

Accession.  "Title  by  accession  is  defined  as  the  right 
to  all  which  one's  own  property  produces,  either  naturally  or 
artificially.  This  includes  the  crops  yielded  by  land;  the  in- 
crease of  animals;  the  uniting  of  the  property  of  one  with  the 
property  of  another,  as  when  an  artist  paints  a  picture  on  the 
canvas  of  another,  the  whole  belongs  to  the  artist,  but  the 
other  has  a  claim  for  the  value  of  the  materials.  Also  by  the 
mixing  or  confusion  of  goods,  which  occurs  when  one  person 
wilfully  mingles  his  own  goods  with  another  that  they  cannot 
be  distinguished  from  each  other.  If  the  mixing  was  by  consent, 
each  has  a  pro  rata  interest  in  the  entire  mass. 

Intellectual  Labor.  "Authors,  composers,  and  inventors 
have  the  exclusive  use  and  control  for  a  limited  time  in  such 
personal  property  as  owes  its  existence  or  value  to  their  skill 
and  labor.  The  general  doctrine  is  that  one  has  a  proprietary 
right  in  the  product  of  his  intellectual  labor  and  that  this  right 
should  be  protected  by  law  for  the  purpose  of  promoting  science, 
encouraging  literature,  and  stimulating  inventions. 

"A  copyright  is  a  grant  to  authors  of  the  exclusive  right 
to  possess,  use  and  dispose  of  their  intellectual  productions. 


140 

This  gives  the  owner  the  right  of  making,  publishing,  and 
selling,  or  authorizing  others  to  do  so  for  a  period  of  twenty- 
eight  years,  with  the  privilege  of  a  renewal  and  extension  for 
a  further  term  of  twenty-eight  years. 

"A  copyright  may  be  secured  for  books,  periodicals,  lec- 
tures, sermons,  addresses,  dramatic  and  musical  compositions, 
maps,  works  and  reproductions  of  works  of  art,  drawings, 
photographs,  prints,  pictorial  illustrations,  motion  pictures, 
etc. 

"A  patent  is  a  grant  for  the  exclusive  privilege  of  making, 
using,  and  vending,  and  authorizing  others  to  make,  use  and 
vend  an  invention  for  a  period  of  seventeen  years.  The  in- 
vention must  be  a  new  and  useful  art,  machine,  or  composition 
of  matter,  not  before  known  and  used. 


Transfer  of  Property.  "Title  to  personal  property  may 
be  acquired  by  transfer  in  two  general  ways:  (i)  by  act  of 
law;  (2)  by  act  of  the  parties. 

"Transfer  of  title  to  personal  property  by  act  of  law  occurs 
(a)  by  forfeiture,  (b)  judgment,  (c)  intestacy,  and  (d) 
insolvency. 

"(i)  Forfeiture  is  a  loss  of  title  by  the  owner  as  a  punish- 
ment for  a  crime,  a  penalty  for  the  violation  of  law,  or  a  breach 
of  contract.  Title  by  forfeiture  is  practically  obsolete  at  the 
present  time  as  a  punishment  for  crime.  However,  there  may 
be  a  forfeiture  of  goods  for  the  evasion  of  revenue  laws,  or  of 
shares  in  a  corporation  for  a  failure  to  pay  assessments  when 
due. 

"(2)  A  judgment  is  a  decision  or  sentence  of  law  pronounced 
by  a  court  or  other  competent  tribunal  having  authority  as 
the  result  of  proceedings  instituted  for  the  redress  of  an  injury 
or  the  settlement  of  a  controversy.  Title  to  personal  property 
occurs  as  a  result  of  a  decree  entered  in  an  action  whereby  a 
person  becomes  entitled  to  take  property  belonging  to  another. 

"(3)  Intestacy  is  the  state  or  condition  of  a  person  dying 
without  having  made  a  will,  leaving  personal  property  undis- 
posed of.  The  title  is  vested  in  the  administrator  as  a  trustee 
for  the  purpose  of  settling  the  estate,  and  the  property  is  dis- 
tributed in  accordance  with  the  statute  laws  of  the  state  where 
the  deceased  person  resided. 

"(4)  A  bankrupt's  property  is  transferred  by  operation 
of  law  to  an  assignee  or  trustee  who  has  authority  to  administer 
the  same  for  the  benefit  of  the  creditors. 


THEORY  QUESTIONS  141 

"Transfer  of  title  to  personal  property  by  act  of  the  parties 
occurs  in  a  contract  of  sale  which  is  a  transfer  of  the  property 
in  a  thing  for  a  money  consideration  called  a  price.  The  trans- 
fer may  be  by  an  exchange  of  property,  whereby  the  title  in 
property  passes  to  another  in  consideration  of  the  receipt  by 
him  of  other  property.  Again,  it  may  be  in  the  form  of  a  gift 
which  is  the  actual,  voluntary,  and  gratuitous  transfer  of  property 
from  one  person  to  another.  The  gift  must  be  accepted  by  the 
person  to  whom  made,  but  the  acceptance  is  presumed.  Then 
again,  the  transfer  may  be  in  the  form  of  a  written  instrument 
designated  a  will  which  provides  for  the  disposition  of  property 
to  take  effect  after  the  death  of  the  person  who  made  the  will." 


A.    THEORY  QUESTIONS 

1.  Mention  under  what  circumstances,  if  any,  reconstruc- 
tion or  rehabilitation  expenses  of  a  street  railway  company  may 
properly  be  charged  to  property  accounts.  C.  P.  A.  Ind. 

2.  An  alteration  to  existing  equipment  is  made  in  a  fac- 
tory.   State  what  you  would  do  with  the  cost  of  such  alteration. 

C.  P.  A.  Ind. 

3.  Auditing  the  yearly  results  of  a  large  engineering  com- 
pany you  find  that  the  machinery  and  tools,  which  had  been 
regularly  depreciated  for  a  number  of  years,  have,  during  the 
year  under  audit,  been  appraised  by  a  reputable  appraising  com- 
pany, and  have  been  revalued  at  a  larger  sum  than  the  debit 
balances  in  the  books.    How  would  you  dispose  of  the  increased 
value  due  to  the  appraisal?  C.  P.  A.  Ind. 

4.  A  company  purchased  several  machines  and,  in  order 
to  install  them  to  the  best  advantage,  old  machines  which  are 
to  remain  in  use  were  moved  to  make  room  for  them.    The  ma- 
chines were  large  and  had  to  be  taken  apart  before  they  could 
be  moved.     To  what  account  would   the  cost  of  moving  be 
charged  and  why?  C.  P.  A.  Pa. 

5.  You  receive  the  following  letter: 

"We  have  never  had  our  books  audited  but  are 
contemplating  an  audit  now.  Two  of  our  friends  have 
recommended  you  to  us.  Both  have  businesses  similar 
to  ours  but  their  advices  as  to  the  time  required  are  very 
different.  Do  you  carry  out  different  kinds  of  audits? 
If  so,  what  are  the  different  kinds  and  under  what  cir- 
cumstances do  you  recommend  one  kind  and  when 
another?" 

Write  reply.  Inst.  Ex.  1917. 


142 


PUBLIC  ACCOUNTING  AND  AUDITING 

B.    ACCOUNTING  PROBLEMS 


I.     In  the  machinery  account  of  a  company  under  audit, 
you  find  the  following  among  other  items : 


Cr. 

Sale  of  old  machine, 

type  A  (less  cost 

of    removal    and 

freight) $1,264.00. 

Sale  of  old  machine, 

type  B 1,470.00. 


Dr. 

Purchase  of  two  machines,  type  A, 

including  freight $8,000.00 

Cost  of  removing  a  disused  ma- 
chine, type  B,  to  make  room  for 
new  machine 160.00 

Cost  of  installation  of  two  new  ma- 
chines   280.00 

Alterations  to  four  type  C  machines, 

necessitated  by  change  in  product .      640.00 

Cost  of  moving  two  machines  from 
building  A  to  building  B  to  permit 
of  more  economical  operation,  in- 
cluding reinstallation 270.00 


The  balance  on  Machinery  Depreciation  account  shows  an 
increase  for  the  year  of  the  amount  provided  out  of  income, 
which  is  computed  at  the  rate  of  4%  on  the  balance  of  Ma- 
chinery account  at  the  commencement  of  the  year.  The  method 
of  keeping  the  Machinery  and  Machinery  Depreciation  accounts 
has  been  in  force  from  the  commencement  of  operations.  Draft 
your  comments  as  auditor  of  these  accounts,  assuming  that 
no  items  other  than  those  above  mentioned  call  for  any  com- 
ments. Inst.  Ex.  1918. 

2.  You  are  called  upon  to  audit  the  books  of  a  partnership 
which  has  been  in  existence  for  one  year.  You  find  that  A's 
Balance  Sheet,  prepared  just  before  B  was  admitted  as  a  part- 
ner, shows  the  following  accounts: 

Cash  in  the  bank,  $500.00;  real  estate,  $20,000.00;  ma- 
chinery, after  10  per  cent  depreciation,  $40,000.00;  accounts 
receivable,  $7,542.50;  stock  on  hand  finished,  $10,000.00;  stock 
in  process  of  construction,  $1,000.00;  raw  material,  $957.50; 
bills  payable,  $20,000.00;  accounts  payable,  $30,000.00. 

After  examining  the  copartnership  agreement,  you  find  that 
A  agreed  with  B  to  sell  him  one-half  interest  in  the  business  for 
the  sum  of  $20,000.00  to  be  contributed  to  the  new  firm,  the  new 
firm  to  take  the  assets  of  A  with  the  exception  of  the  real  estate 
and  assume  the  liabilities,  and  that  the  good  will  of  the  business 
of  A  should  be  rated  at  $20,000.00  in  the  new  firm's  books. 

During  the  course  of  your  audit  you  discovered  the  follow- 
ing discrepancies : 

(a)  The    inventory    of   finished    stock   was    incorrect. 

The  value  should  have  been  entered  at  $8,000.00  instead 

of  $10,000.00. 


ACCOUNTING  PROBLEMS  143 

(b)  Of  the  accounts  receivable,  $6,500.00  were  col- 
lectible. One  of  the  debtors  owing  $500.00  failed,  leaving 
no  assets,  previous  to  the  formation  of  the  copartnership, 
which  fact  was  known  to  A  but  his  bookkeeper,  who  had 
been  instructed  to  charge  off  the  account  had  failed  to  do 
so.  $1,000.00  of  the  accounts  receivable  represents  accounts 
ascertained  to  be  worthless  since  the  copartnership  was 
formed. 

The  Trial  Balance  at  the  end  of  the  year's  business  showed 
as  follows: 

A  Capital  Account $  25,000.00 

B  Capital  Account 25,000.00 

Merchandise 75,000.00 

Accounts  Payable 40,000.00 

Accounts  Receivable $10,000.00 

Machinery 40,000.00 

Factory  Wages 35,000.00 

Non-productive  Labor 5,000.00 

General  Factory  Expense ....  20,000.00 

Rent i  ,500.00 

A  Personal  Account 2,500.00 

B  Personal  Account 2,500.00 

General  Expense 2,000.00 

Good  Will 20,000.00 

Cash 26,000.00 

Profit  and  Loss 500.00 


$165,000.00    $165,000.00 
Inventories  at  close  of  year: 

Stock  on  hand  finished $25,000.00 

Stock  in  process  of  construction 2,500.00 

Raw  Material 2,500.00 


Total 30,000.00 

No  correction  was  made  of  the  discrepancies  and  no  amount 
has  been  charged  off  for  depreciation  of  machinery,  which  should 
be  10  per  cent. 

Make  proper  entries  to  correct  books  with  reasons  for  such 
entries  in  full,  also  formulate  Balance  Sheet  showing  the  stand- 
ing of  the  firm  after  the  books  were  closed.  C.  P.  A.  Mich. 

(Note.  In  connection  with  the  second  Accounting  Problem,  there  are 
several  legal  principles  involved.  You  may  assume  that  B  accepted  the  Assets 
and  Liabilities  of  A  as  stated  on  A's  books  with  the  exception  of  the  Account 
Receivable  amounting  to  $500.00  known  to  be  worthless  by  A,  but  which 
was  included  in  his  assets  through  an  error  on  the  part  of  the  bookkeeper. 

The  overvaluation  of  the  inventory  probably  was  unknown  to  both 
A  and  B  until  the  auditor  ascertained  this  fact.  The  accounts  proved  to  be 
uncollectible,  excepting  the  account  mentioned  above,  could  not  be  foretold, 
and  were  accepted  by  A  without  a  reserve  for  such  a  loss,  therefore,  you  may 
assume  that  these  two  items  are  losses  of  the  partnership  to  be  borne  equally 
by  A  and  B. 


144  PUBLIC  ACCOUNTING  AND  AUDITING 

As  a  result  of  this  information,  two  correcting  and  two  adjusting  entries 
are  necessary.  These  should  be  set  up  in  journal  form  and  posted  to  the 
accounts,  after  which  a  Trial  Balance  should  be  taken  and  a  Balance  Sheet 
made.) 

C.    LEGAL  QUESTIONS. 

1.  Name  the  two  divisions  of  property  and  explain  each. 

2.  Define  personal  property. 

3.  What   is   chattel    property? 

4.  When  are  trees  real  property  and  when  are  they  per- 
sonal property? 

5.  (a)  Name   four   methods   by   which   title   to   personal 
property  may  be  transferred  by  acts  of  law. 

(b)  May  personal  property  be  transferred  by  acts  of 
the  parties?     If  so,  explain  how. 


Chapter  Ten 


DEPRECIATION 

Depreciation  Defined.  Depreciation  is  the  shrinkage  in 
value  of  an  asset  due  to  deterioration  through  wear  and  tear 
caused  by  use  or  by  a  mere  lapse  of  time,  accidents,  inadequacy, 
or  obsolescence.  The  importance  of  its  being  considered  from 
an  accounting  standpoint  can  hardly  be  overestimated.  Without 
a  doubt,  failure  to  provide  for  the  depreciation  of  the  fixed 
assets,  has  contributed  to  the  failure  of  many  concerns  in  the 
past. 

In  a  decision  by  the  New  York  Court  of  Appeals,  the  fol- 
lowing statement  appears: 

"Judicial  notice  may  be  taken  of  the  fact  that  in  the  con- 
duct of  many  industrial  enterprises  there  is  a  constant  deter- 
ioration of  the  plant  which  is  not  made  good  by  ordinary  re- 
pairs and  which,  of  course,  operates  continually  to  lessen  the 
value  of  the  tangible  property  which  it  affects.  The  amount 
of  this  depreciation  differs  in  different  enterprises,  but  the  annual 
rate  is  usually  capable  of  estimate  and  proof  by  skilled  witnesses. 
No  corporation  would  be  regarded  as  well  conducted  which  did 
not  make  some  provision  for  the  necessity  of  ultimately  replacing 
the  property  thus  suffering  deterioration;  and  we  cannot  see 
why  an  allowance  for  this  purpose  should  not  be  made  out  of 
the  gross  earnings  in  order  to  ascertain  the  true  earning  capacity." 
A  few  years  ago  an  underwriting  syndicate  undertook  the 
reorganizing  of  the  Rock  Island  Companies.  Its  plans  were  to 
issue  7  per  cent  preferred  stock  on  the  basis  of  an  8  per  cent 
income.  To  the  dismay  of  the  members  of  the  syndicate,  the 
Interstate  Commerce  Commission  ruled  that  all  the  railroads 
under  its  control  must  include,  as  a  charge  against  their  profits,  a 
satisfactory  percentage  of  the  railroad  equipment,  such  percent- 
age being  the  estimated  amount  of  depreciation  of  the  property. 
As  a  result  of  this  ruling  the  net  income  of  the  Rock  Island 
Companies  fell  to  3^  per  cent.  This  rate  of  income  was  insuf- 
ficient to  warrant  the  issue  of  7  per  cent  stock  and  the  syn- 
dicate collapsed.  The  practice  of  most  of  the  railroad  companies 
had  been  to  disregard  the  theory  of  depreciation.  They  simply 
discarded  old  equipment  made  worthless  through  wear  and  tear 
and  borrowed  money  to  buy  new  equipment.  It  dosen't  require 
much  wisdom  to  see  the  folly  of  such  a  plan  and  the  ultimate 
results  are  quite  clear.  A  firm  that  divides  all  its  net  income 
without  providing  for  depreciation  on  its  fixed  assets  is  simply 
"robbing  Peter  to  pay  Paul"  and  it  reminds  one  of  the  story  of 
the  two  men,  shipwrecked  on  a  deserted  island,  who  during  the 
time  they  were  stranded  became  rich  trading  knives  with  each 
other. 


146  PUBLIC  ACCOUNTING  AND  AUDITING 

Causes  of  Depreciation.  There  are  four  principal  causes 
of  depreciation.  These  have  been  so  ably  and  clearly  described 
by  Professor  M.  E.  Cooley  that  we  will  quote  him  in  detail: 

"i.  Depreciation  Due  to  Wear  and  Tear  and  Exposure 
to  the  Elements.  This  is  continuous.  All  elements  have  a  wear- 
ing life  varying  with  the  element  itself.  No  element  can  be 
completely  worn  out;  it  can  be  worn  only  to  a  point  below 
which  it  becomes  unsafe  or  no  longer  serves  its  original  function. 
In  practice,  the  average  condition  of  all  elements  must  be  main- 
tained at  a  high  percentage  of  the  original  cost  if  the  property 
is  to  serve  its  purpose  properly.  This  percentage  varies  from 
75  per  cent  to  85  per  cent  of  the  cost  of  the  property.  The 
difference  between  this  percentage  of  from  75  to  85  and  the 
original  100  is  a  depreciation  which  is  inherent  in  the  property 
and  cannot  be  dispensed  with.  It  must  be  met  by  a  sinking 
fund,  or  its  equivalent,  otherwise  this  part  of  the  original  invest- 
ment is  lost. 

"2.  Depreciation  Due  to  Accidents;  Sudden  Depreciation. 
An  engine  or  a  boiler  may  be  wrecked,  and  with  it,  other  machin- 
ery. This  might,  and  probably  would,  involve  a  considerable 
expense  for  repairs  or  replacements  besides  possibly  crippling 
the  plant  in  part.  Cars  may  collide  or  a  car  may  drop  through 
a  bridge.  A  bridge  itself  may  fall  or  be  carried  away  by  flood. 
A  storm  or  a  cyclone,  may  work  havoc,  entailing  costs  in  excess 
of  those  proper  to  be  charged  to  ordinary  maintenance  of  property. 

"3.  Depreciation  Due  to  Inadequacy.  Cars  suitable  in  the 
past  had  already  been  superceded  several  times  by  larger  and 
better  cars.  This  has  rendered  the  track,  structure,  and  bridges 
inadequate,  and  as  more  power  is  required  to  propel  the  larger 
cars,  the  power  plants  have  become  inadequate.  The  public 
demand  is  largely  responsible  for  this  depreciation  due  to  in- 
adequacy. 

"4.  Depreciation  Due  to  Obsolescence.  This,  while  closely 
allied  to  the  depreciation  due  to  inadequacy,  is  different  in  that 
it  embraces  changes  due  to  advance  in  the  art.  More  efficient 
and  effective  machinery  has  appeared  which  must  be  substituted 
for  the  old  to  keep  abreast  of  the  times.  For  example,  in  steam- 
engine  practice  the  turbine  has  come  into  geneial  use  during  the 
past  five  years  and  the  art  of  steam  turbines  is  at  the  beginning. 
Generators  adapted  to  piston-engine  practice  are  not  adapted 
to  steam-turbine  practice  and  must  be  changed.  Boilers 
adapted  to  piston-engine  practice  must  be  replaced  to  carry  the 
higher  pressures  required.  Condensers  must  also  be  changed 
to  secure  the  better  vacuum  required  to  realize  the  full  advantage 
of  the  steam  turbine.  Owing  to  the  rapid  disappearance  of 
coal  beds,  the  price  of  fuel  must  advance,  and  this  presumably 
will,  before  many  years,  force  the  adoption  of  the  gas  producer 
and  the  producer  gas  engine.  Water  powers  are  wisely  being 
developed,  but  to  utilize  them  requires  the  scrapping  of  large 
parts  of  the  machinery  in  use  at  present." 


DEPRECIATION  147 

In  regulating  depreciation  in  respect  to  income  taxes,  de- 
duction is  allowed  only  for  loss  due  to  wear  and  tear  of  property 
used  in  the  trade  or  business.  This  does  not  include  provision 
for  obsolescence  since  it  is  provided  that  when  an  asset  is  actually 
determined  to  be  obsolete  the  loss  may  be  deducted  at  that 
time.  However,  obsolescence  should  usually  be  provided  for 
periodically  as  well  as  depreciation  from  wear  and  tear,  as  the 
government's  permission  to  make  eventual  deduction  for  loss 
from  obsolescence  does  not  justify  a  waiver  of  the  fundamental 
accounting  rule  to  provide  for  all  possible  losses. 

Factors  Bearing  on  Amount  of  Depreciation.  In  de- 
termining the  probable  amount  of  depreciation  on  any  fixed 
asset  there  are  certain  factors  to  be  taken  into  consideration 
such  as  original  or  prime  cost,  probable  life  of  the  asset,  repairs 
and  replacements,  residual  or  scrap  value  and  the  possibility 
of  obsolescence. 

1 .  The  original  or  prime  cost  is  the  basis  of  all  calculations. 
It  should  include  all  the  elements  of  cost  such  as  freight  and  cart- 
age inward,  cost  of  installation,  etc. 

2.  The  probable  life  of  the  asset,  or  the  number  of  years  it 
is  estimated  to  be  of  use,  is  the  next  factor  to  be  considered. 
This  varies  so  extensively,  even  with  the  same  kinds  of  machines, 
or  other  assets,  that  it  is  always  a  difficult  item  to  arrive  at  with 
any  degree  of  accuracy.     About  the  only  way  of  determining 
the  life  of  an  asset  is  by  experience. 

Earl  A.  Saliers,  author  of  "Principles  of  Depreciation",  says: 
"But  efficiency,  the  test  of  present  usefulness,  is  not  the 
only  factor  that  determines  value.  Value  depends  upon  the 
length  of  time  over  which  such  usefulness  will  continue.  Two 
similar  machines  may  be  equally  efficient  today;  but  one  may 
continue  to  be  useful  for  two  years  and  the  other  for  four.  Can 
we  say  that  they  have  equal  value?  There  may  be  some  uncer- 
tainty in  individual  cases;  but  the  uncertainty  is  limited  within 
certain  bounds,  and  to  a  great  degree  vanishes  when  averages  are 
considered,  just  as  the  uncertainties  of  lifetime  vanish  when 
large  numbers  of  lives  are  considered.  The  lifetime  of  a  single 
freight  car  is  very  uncertain  but  the  average  lifetime  of  a  thou- 
sand cars  is  ascertainable  to  the  fraction  of  a  year." 

3.  Repairs  and  replacements  of  property  affect  the  rate 
of  depreciation,  consequently,  the  auditor  should  not  decide  on 
the  amount  required  for  depreciation  until  he  has  scrutinized 
the  Repairs  and  Maintenance  account.  He  may  find  items  charged 
to  this  account  that  should  have  been  charged  to  the  Reserve 
for  Depreciation  account  because  they  represent  expenditures 
that  decrease  the  deterioration  and  should  have  the  effect  of  re- 
ducing the  depreciation  charge. 

The  usual  procedure  in  practice  is  to  charge  all  items 
representing  repairs  and  replacements  to  either  expense  or  to 
the  Reserve  for  Depreciation  account.  In  deciding  which  account 
should  be  charged  it  is  necessary  to  determine  whether  the 


148  PUBLIC  ACCOUNTING  AND  AUDITING 

expenditure  is  one  provided  for  through  cumulative  depreciation 
allowances.  Ordinarily  small  incidental  items  of  repair,  replace- 
ment and  maintenance  are  charged  to  expense  and  larger  items 
of  renewal  and  replacement  are  charged  to  the  depreciation 
reserve.  Remember,  that  with  either  plan  it  is  a  deduction 
from  income,  but  the  point  in  question  is,  that  the  expenditure 
must  not  be  charged  to  expense,  and  at  the  same  time,  another 
charge  be  made  on  account  of  depreciation.  (See  page  154  for 
Income  Tax  Procedure). 

Like  nearly  all  rules,  there  is  an  exception  here  in  connection 
with  old,  run-down  or  partially  worn-out  assets  purchased  with 
the  intention  of  remodeling,  rebuilding  or  rehabilitating  them 
so  they  can  be  operated  efficiently  again.  In  such  cases,  it 
is  permissible  to  charge  all  repairs  and  renewals  to  the  asset 
accounts  affected,  thereby  capitalizing  such  expenditures. 

4.  The  total  amount  of  depreciation  of  an  asset  will  be 
the  difference  between  its  original  cost  and  its  residual  or  scrap 
value  when  it  ceases  to  be  useful  and  must  be  discarded.    What- 
ever can  be  realized  from  the  sale  of  an  asset  at  the  time  it  is 
discarded  reduces  the  loss  and  thereby  the  amount  of  depre- 
ciation. 

5.  Some  assets  are  quite  likely  to  become  obsolete  even 
before  they  have  become  useless  through  wear  and  tear.     The 
possibility  of  obsolescence,  therefore,  is  a  matter  for  consider- 
ation. 

Methods  Used  for  Calculating  the  Depreciation.  There 
are  several  methods  advocated  for  calculating  the  proper  amount 
or  rather  the  annual  rate  of  depreciation.  We  shall  discuss 
briefly  the  principal  methods  used. 

I.  Straight  Line  Method.  In  this  method  the  life  of  the 
asset  is  estimated  and  the  cost  of  such  asset  less  its  scrap  or 
residual  value  is  written  off  over  such  estimated  life.  The  amount 
of  depreciation  for  each  year  is  found  by  dividing  the  difference 
between  the  cost  and  residual  value  by  the  number  of  years  of 
the  estimated  life  of  the  asset. 

To  illustrate,  let  us  assume  that  the  cost  of  a  certain  ma- 
chine is  $81.00,  its  estimated  life  is  four  years,  and  its  residual 
or  scrap  value  is  $16.00. 

By  deducting  the  scrap  value,  $16.00,  from  the  cost,  $81.00, 
we  get  $65.00,  the  amount  the  machine  is  expected  to  depreciate 
in  four  years,  its  estimated  life.  $65.00  divided  by  the  number 
of  years,  four,  shows  $16.25,  the  annual  amount  of  depreciation 
to  be  charged  off.  The  amount  of  annual  depreciation,  $16.25 
divided  by  the  cost,  $81.00,  shows  the  rate  of  depreciation 
to  be  20  5/81%. 

This  is  the  simplest  method  for  calculating  depreciation  and 
consequently  is  very  popular.  It  is  the  method  in  general  use, 
and  is  acceptable  to  the  Interstate  Commerce  Commission  and 
the  Internal  Revenue  Department.  The  method  has  been 
criticized  by  some  accountants  and  others  for  various  reasons. 


DEPRECIATION  149 

Sailers  says  in  this  connection: 

"It  is  free  from  interest  complications,  and  its  employment 
does  not  require  a  knowledge  of  the  logarithmic  or  any  other 
method  of  finding  roots  and  powers  of  numbers.  Speaking 
generally,  there  appears  to  be  no  reason  why  the  straight  line 
method  does  not  approximate  actual  depreciation  as  nearly 
as  any  of  the  complicated  curves  at  times  advocated,  apparently 
on  the  assumption  that  actual  depreciation  finds  a  counter- 
part in  the  accuracy  of  their  mathematical  computations." 

2.  Diminishing  Value  Method.     In  this  method  it  is  cus- 
tomary to  estimate  a  minimum  life  of  the  asset  and  then  depre- 
ciate the  residual  value  each  year.    That  is,  instead  of  basing  the 
annual  depreciation  during  the  life  of  the  asset  on  the  original 
cost,  as  in  the  straight  line  method,  it  is  based  on  the  value  of 
the  asset  at  the  beginning  of  that  period  after  having  deducted 
the  total  amount  of  previous  depreciation.     A  percentage  rate 
is  ascertained  which,  when  applied  each  year  to  the  balance 
remaining  after  the  similar  deduction  for  the  preceding  year, 
will  reduce  the  balance  to  the  scrap  value  at  the  end  of  life  of 
the  asset. 

Using  the  same  problem  as  shown  under  the  straight  line 
method,  it  will  be  seen  that  it  requires  a  rate  of  33^%  to  reduce 
the  asset  to  a  scrap  value  of  $16.00  in  four  years.  Note  the  fol- 
lowing calculations : 

Original  cost  of  machine $81 .00 

Less  Depr.  (33^%  of  $81.00) 27.00 

Value  beginning  of  second  year 54.00 

Less  Depr.  (33^%  of  $54.00) 18.00 

Value  beginning  of  third  year 36.00 

Less  Depr.  (33^%  of  $36.00) 12.00 

Value  beginning  of  fourth  year 24.00 

Less  Depr.  (33^3%  of"  $24.00) 8.00 

Residual  or  scrap  value $16.00 

It  will  be  seen  that  the  amount  of  depreciation  is  greater 
at  the  beginning  but  decreases  with  the  life  of  the  asset.  It 
is  held  by  some  that  this  is  reasonable  because  the  cost  of  repairs 
and  maintenance  is  least  while  the  asset  is  new  but  increases 
as  the  asset  is  used.  Therefore,  the  total  depreciation  and  up- 
keep will  be  nearly  uniform  each  year.  On  the  other  hand, 
the  concern  is  forced  to  charge  off  a  larger  amount  of  depreciation 
at  the  beginning  of  its  existence  when  profits  may  be  small. 
Another  objection  is  the  fact  that  it  involves  a  complicated 
mathematical  calculation,  and  the  annual  rate  of  depreciation 
gives  little  indication  to  the  ordinary  man  of  the  period  required 
to  write  off  the  asset. 

3.  Annuity  Method.     In  this  method  the  plan  is  to  esti- 
mate an  amount  which,  if  annually  set  aside  at  interest,  would  at 
the  end  of  the  life  of  the  asset  amount  to  the  difference  between 
cost  and  scrap  values.     A  sum  is  determined  which,  when  set 


150  PUBLIC  ACCOUNTING  AND  AUDITING 

aside  each  year  at  compound  interest,  will  accumulate,  during 
the  life  of  the  asset,  and  will  just  equal  the  scrap  value  at  the 
end  of  its  estimated  life. 

Hatfield,  in  his  Modern  Accounting,  says: 

"It  rests  upon  the  assumption  that  the  cost  of  production 
includes  not  only  repairs  and  the  depreciation  of  machinery, 
but  as  well,  interest  on  the  amount  of  capital  invested  in  the 
asset.  Depreciation  on  this  theory  should  be  a  sum  figured  as 
a  constant  annual  charge  sufficient  not  only  to  write  off  the 
decline  in  value,  but  also  to  write  off  annual  interest  charges 
on  its  diminishing  value." 

Using  the  same  problem  as  above,  it  will  be  seen  that  the 
annual  amount  of  depreciation  is  equivalent  to  a  rate  of  27 
47/162%  based  on  the  original  cost.  Note  the  following  cal- 
culations: 

Original  cost  of  machine $81 .00 

Interest  at  10% 8.10 

89.10 
Depreciation  first  year  (27  47/162%) 22. 10 

Value  beginning  of  second  year 67 .00 

Interest  at  10% 6 . 70 


73-70 
Depreciation  second  year  (27  47  /i62%) 22 . 1 1 

Value  beginning  of  third  year 51-59 

Interest  at  10% 5.16 

56.75 
Depreciation  third  year  (27  47/162%) 22. 10 

Value  beginning  of  fourth  year 34-65 

Interest  at  10% 3 . 46 


Depreciation  fourth  year  (27  47/162%) 22.11 

Residual  or  scrap  value $16.00 

(Interest  at  the  rate  of  10  per  cent  was  used  for  convenience 
in  arithmetical  calculations.) 

This  method  is  objectionable  because  of  the  inclusion  of 
interest  on  invested  capital.  Of  course,  the  writing  up  of  the 
asset  is  offset  by  the  increased  depreciation.  The  method  is 
inconsistent  unless  interest  is  charged  on  all  the  capital  invested. 

4.  Production  Unit  Method.  In  this  method  the  estimated 
life  of  an  asset  is  based  on  its  production.  The  plan  is  to  charge 
off  an  established  rate  per  unit  of  output.  It  may  be  applied 


DEPRECIATION  151 

to  such  assets  as  diminish  in  value  in  exact  ratio  to  the  amount 
used.  For  instance,  if  the  machine  mentioned  above  was 
designed  to  produce  1,000,000  units  at  a  total  cost  of  $1,000.00, 
the  depreciation  charge  would  be  I  mill  per  unit  of  production. 

Comparison  of  Methods  for  Calculating  Depreciation. 

Walton  says  with  regard  to  the  significance  of  each  method: 

"(a)  The  Straight  Line  Method  distributes  the  burden  of 
depreciation  equally  over  all  the  years,  without  regard  to  the 
constantly  increasing  repairs. 

"(b)  The  Diminishing  Value  Method  starts  with  a  heavier 
burden  of  depreciation  which  gradually  diminishes,  the  theory 
being  that  as  the  repairs  increase  on  account  of  the  increasing 
deterioration  of  the  asset,  the  decreased  depreciation  tends  to 
equalize  the  burden  over  the  years.  It  also  provides  for  a 
residual  or  scrap  value,  as  the  carrying  value  never  reaches 
zero. 

"(c)  The  Annuity  Method  takes  into  consideration  not 
only  the  cost  of  the  asset,  but  also  the  interest  on  the  diminishing 
value.  As  the  credit  to  interest  diminishes  each  year  and  the 
charge  for  depreciation  remains  constant,  the  net  expense 
increases  annually.  In  addition,  few  accountants  are  in  favor 
of  considering  interest  on  the  cost  of  fixed  assets  as  an  operating 
expense." 

Dicksee,  a  prominent  authority,  favors  the  first  method 
for  short-lived  assets,  the  second  for  machinery  in  general,  and 
the  third  for  long-time  terminable  leaseholds  and  similar  assets. 
Where  courts  have  prescribed  depreciation,  they  have  generally 
allowed  the  basis  of  calculation  to  be  left  to  the  discretion  of 
the  company.  This  is  also  true  with  the  Internal  Revenue 
Department.  The  Interstate  Commerce  Commission  prescribes 
the  first  method  for  figuring  depreciation.  It  is  compulsory 
with  concerns  coming  under  the  Commission's  Control. 

Accounting  Procedure  with  Regard  to  Depreciation. 

Either  a  reserve  for  depreciation  or  a  reserve  fund  may  be 
created,  or  the  asset  account  may  be  credited  direct  for  the 
amount  of  the  depreciation. 

(a)  Writing  Down  the  Asset.     If  the  amount  is  credited 
direct  to  the  asset  account,  it  is  known  as  writing  down  the  asset. 
The  principal  objection  to  this  plan  is  that  the  original  cost  of 
the  asset  is  lost  sight  of.     From  an    accounting  standpoint,  the 
asset  accounts  should  show  costs  of  assets  on  hand  at  the  date 
of  the  Balance  Sheet.     If  the  depreciation  is  credited  direct  to 
the  accounts  with  assets,  this  policy  is  interfered  with  making 
it  necessary  to  analyze  the  accounts  in  order  to  ascertain  the 
cost  of  assets. 

(b)  General  Reserve  for  Depreciation.    Some  firms  create 
a  general   reserve  for  depreciation.     This  is  considered   poor 
accounting  for  the  reason  that  the  account  includes  the  depre- 
ciation on  all  classes  of  assets  and  it  is  impossible  to  ascertain 


152  PUBLIC  ACCOUNTING  AND  AUDITING 

the  net  carrying  value  of  any  particular  asset  or  class  of  assets 
without  first  analyzing  the  account.  It  is  also  difficult,  if  not 
impossible,  to  verify  its  accuracy  as  time  shows  how  much  the 
actual  depreciation  on  a  special  class  of  assets  has  been.  It  will 
be  seen,  therefore,  that  the  same  objections  may  be  made  to 
either  of  these  plans. 

(c)  Specific  Reserve  for  Depreciation.     Without  a  doubt 
this    is    the   best   plan   of   all.     The   amount   of  depreciation 
is  credited  to  a  reserve  for  depreciation  on  each  asset  affected. 
This  reserve  is  then  deducted  from  the  asset  to  which  it  applies 
in  the  Balance  Sheet  so  that  the  asset  is  shown  at  its  cost,  less 
depreciation,  and  its  present  value  shown  as  a  current  or  fixed 
asset.     This  is  the  net  carrying  value  to  the  business. 

(d)  Reserve  Funds.     In  all  the  above  methods  the  effect 
of  the  provision  for  depreciation  is  simply  to  provide  for  depre- 
ciation and  deterioration  by  setting  aside  a  part  of  the  profits 
annually  and  preventing  their  distribution.     However,  creating 
the  reserve  does  not  set  apart  a  specific  sum  and  label  it  for 
the  purpose  of  replacing  certain  assets.    Creating  a  reserve  fund 
is  entirely  different  from  creating  a  reserve  for  depreciation. 
The  object  of  the  reserve  fund  is  to  set  aside  annually  a  certain 
sum  estimated  to  be  sufficient  to  replace  a  certain  asset  when 
it  has  become  worthless  or  obsolete.    In  the  first  three  methods 
outlined  above,  the  problem  of  interest  does  not  arise.     When 
a  reserve  fund  is  created  and  a  certain  sum  set  aside  and  invested 
in  securities,  these  securities  will  earn  interest  which   in   itself 
may  increase  the  fund  or  may  be  treated  as  an  income  on  the 
books  and  not  a  part  of  the  fund.    While  this  plan  has  its  ad- 
vantages, at  the  same  time  it  reduces  the  working  capital  of 
the  company  by  tying  up  a  certain  part  of  its  funds  in  such  a 
manner  that  they  cannot  be  used  for  any  other  purpose  than 
that  for  which  they  were  intended.     By  the  reserve  for  depre- 
ciation methods,  that  part  of  the  profits  set  aside,  are  retained 
in  the  business  as  working  capital  and  may  be  reinvested  in 
stock-in-trade  or  other  assets,  the  income  from  which  will  very 
likely  be  greater  than  could  be  realized  from  a  reserve  fund 
invested  in  conservative  securities. 

In  order  to  illustrate  the  four  methods  explained  above, 
let  us  assume  that  the  depreciation  on  a  certain  machine  costing 
$1000.00  amounted  to  10  per  cent  the  first  year,  or  $100.00. 
Under  the  first  plan  a  journal  entry  would  be  made  as  follows: 

Manufacturing  Expense $100.00 

Machinery $100.00 

Note  that  the  Machinery  account  is  credited  for  the  amount 
of  the  depreciation  thus  reducing  its  value  on  the  books. 

Under  the  second  plan  the  following  entry  would  be  made: 

Manufacturing  Expense $100.00 

Reserve  for  Depreciation $100.00 

A  general  Reserve  for  Depreciation  account  is  here  credited. 
The  same  account  would  also  be  credited  for  the  amount  of 


DEPRECIATION  153 

depreciation  on  buildings,  furniture,  delivery  equipment  and 
possibly  even  for  a  reserve  for  doubtful  accounts.  The  asset 
account  with  Machinery  is  not  affected  by  the  entry. 

Under  the  third  plan  the  following  entry  would  be  made: 

Manufacturing  Expense $100.00 

Reserve  for  Depr.  on  Machinery.  $100.00 

A  special  Reserve  for  Depreciation  on  Machinery  account 
is  credited.  The  asset  account  with  machinery  is  not  affected. 
In  stating  the  value  of  machinery  in  the  Balance  Sheet,  the 
reserve  for  depreciation  on  machinery  is  deducted  and  only 
the  net  amount  listed  as  an  asset. 

Under  the  last  plan  two  entries  are  necessary,  the  first  setting 
up  the  depreciation  and  the  second  establishing  the  reserve 
fund. 

(First   Entry) 

Manufacturing  Expense $100.00 

Reserve  for  Depr.  of  Machinery.  $100.00 

(Second  Entry) 

Reserve  Fund $100 .  oo 

Cash $100.00 

It  will  be  seen  that  the  first  entry  is  the  same  as  that  under 
the  third  plan  above.  The  second  entry  is  entirely  different 
and  is  really  no  part  of  the  depreciation  entry.  After  this  last 
entry  has  been  made  the  cash  would  be  turned  over  to  a  trustee, 
much  the  same  as  in  the  case  of  a  sinking  fund,  and  he  would 
be  instructed  as  to  the  handling  of  the  fund.  It  is  usually 
invested  in  high-grade  securities. 

Appreciation.  It  is  always  unwise  to  write  up  the  value  of 
assets  even  when  they  have  undoubtedly  increased  in  value.  If  we 
are  to  stick  to  the  rule  that  no  profit  can  be  made  except  through 
sales,  then  we  can  never,  under  any  circumstances,  show  appre- 
ciation of  assets  by  increasing  their  book  value. 

Sometimes  it  is  held  that  the  appreciation  offsets  the  de- 
preciation and  that  no  provision  for  depreciation  need  be  made. 
For  instance,  the  increase  in  the  market  value  of  agricultural 
land,  might  be  such  that  it  would  seem  that  no  depreciation 
should  be  considered.  The  fact  is  that  the  present  increase  in 
market  value  is  a  mere  fluctuation  in  prices  and  may  suddenly 
decrease  while  the  productive  value  would  not  in  the  least  be 
affected  by  such  fluctuation.  Experience  has  shown  clearly 
that  agricultural  land  is  depreciating  in  productive  value  through 
its  use.  At  present  the  upkeep  is  not  such  as  to  maintain  the 
original  productive  value  of  such  land  and  therefore,  it  is  ad- 
visable to  provide  for  certain  depreciation. 

Under  no  circumstances  should  an  estimated  appreciation 
of  one  asset  be  considered  to  have  offset  the  depreciation  of 
the  same  or  another  asset. 


154  PUBLIC  ACCOUNTING  AND  AUDITING 

INCOME  TAX  PROCEDURE 

Depreciation  is  a  Proper  Deduction  from  Income.    It 

has  been  shown  that  depreciation  is  an  operating  expense  and 
that  it  should  be  charged  off  by  writing  down  the  value  of  the 
fixed  assets  or  by  setting  up  a  reserve  for  depreciation,  preferably 
the  latter.  The  Income  Tax  Law  has  clearly  recognized  this 
theory. 

Income  Tax  Law.  Section  214  (a-8)  [Individuals];  Sec- 
tion 234  (a-y)  [Corporations].  "In  computing  net  income 
there  shall  be  allowed  as  deductions: 

"A  reasonable  allowance  for  the  exhaustion,  wear  and  tear 
of  property  used  in  the  trade  or  business." 

Capital  Expenditures  not  Deductible.  Expenditures 
which  actually  increase  the  value  of  the  assets  cannot  be  deducted 
as  an  expense. 

Income  Tax  Law.  Section  215  for  individuals  and  Sec- 
tion 235  for  corporations.  "That  in  computing  net  income  no 
deduction  shall  in  any  case  be  allowed  in  respect  of — 

"Any  amount  paid  out  for  new  buildings  or  for  permanent 
improvements  or  betterments  made  to  increase  the  value  of  any 
property  or  estate." 

Replacements  and  Renewals  must  not  be  Deducted 
Twice.  As  previously  explained  expenditures  for  repairs  and 
replacements  cannot  be  deducted  as  an  expense  and  again  be 
provided  for  through  a  depreciation  reserve. 

Income  Tax  Law.  Section  214.  (c)  "That  in  computing 
net  income  no  deduction  shall  in  any  case  be  allowed  in  respect 
of— 

"Any  amount  expended  in  restoring  property  or  in  making 
good  the  exhaustion  thereof  for  which  an  allowance  is  or  has  been 
made." 

(Reg.  No.  33,  1918,  ^  432.)  "The  cost  of  incidental  repairs 
which  neither  add  to  the  value  of  the  property  nor  appreciably 
prolong  its  life,  but  keep  it  in  an  ordinarily  efficient  operating 
condition,  may  be  deducted  as  expense,  provided  that  the  plant 
or  property  account  is  not  increased  by  the  amount  of  such 
expenditures.  Such  repairs,  to  the  extent  that  they  arrest 
deterioration,  should  have  the  effect  to  reduce  the  depreciation 
charge  otherwise  deductible." 

Income  Tax  Primer,  1918,  question  99.  Ruling.  "If  a 
tax  payer  wishes  to  claim  the  full  amount  of  depreciation  es- 
timated to  have  occurred  in  the  value  of  a  building  or  other 
property  used  for  business  or  trade  purposes,  he  may  do  so, 
but  this  precludes  his  claiming  a  deduction  to  cover  any  amount 
expended  during  the  same  year  in  making  repairs.  If  he  wishes 
to  claim  a  deduction  on  account  of  repairs,  their  cost  must  be 
deducted  from  the  full  amount  of  depreciation,  and  the  balance 


DEPRECIATION  155 

may  then  be  claimed  as  a  deduction  under  the  heading  of  'De- 
preciation'; that  is,  if  the  tax  payer  expends  $100.00  in  making 
repairs  to  a  building  which  will  depreciate  in  value  $200.00 
during  the  calendar  year  he  may  claim  $100.00  as  a  business 
expense  and  $100.00  as  depreciation,  or  he  may  claim  $200.00 
as  depreciation  and  nothing  for  repairs,  in  short,  the  aggregate 
deductions  claimed  on  account  of  repairs  and  depreciation 
must  not  exceed  the  full  amount  of  depreciation  estimated  to 
have  occurred.  (Note — The  repairs  referred  to  in  this  para- 
graph are  such  as  are  general  in  character,  represent  replace- 
ments, etc.  Small  items,  such  as  replacement  of  broken  window 
panes,  papering,  minor  repairs,  etc.,  are  allowable,  even  though 
full  amount  of  depreciation  has  been  claimed.)" 

Depreciation  must  be  Entered  on  the  Books  or  it  Will 
not  be  Deductible.  The  1918  law  does  not  specify  that  de- 
preciation must  be  charged  off  on  the  books  of  an  individual  or 
a  corporation,  but  the  commissioner  is  given  ample  power  to 
enforce  proper  accounting  methods  and  the  following  regulations 
show  that  he  has  done  so. 

(Reg.  No.  33,  1918,  ^[  484.)  "Within  the  purview  of  this 
item  depreciation,  to  an  amount  measuring  the  decline  in  value 
due  to  exhaustion,  wear  and  tear  of  property  arising  out  of  its 
use,  is  a  loss.  This  loss,  in  order  to  constitute  an  allowable 
deduction  from  gross  income,  must  be  charged  off.  The  particu- 
lar manner  in  which  the  amount  shall  be  charged  off  is  not 
material,  except  that  the  amount  measuring  a  reasonable  allow- 
ance for  depreciation  must  be  either  deducted  directly  from  the 
book  value  of  the  assets  or  credited  to  a  Depreciation  Reserve 
account,  and  as  such  shall  be  reflected  in  the  annual  Balance 
Sheet." 

(Reg.  No.  33,  1918,  ^[  480.)  "The  fact  that  no  reserve  was 
made  for  depreciation  indicates  that  there  is  no  loss  on  this  ac- 
count to  be  provided  for." 

Basis  of  Depreciation.  (T.  D.  2754,  Aug.  23,  1918.)  "A 
reasonable  allowance  for  the  wear  and  tear  of  property  arising 
out  of  its  use  or  employment  in  the  business  or  trade  is  to  be  based 
on  the  cost  of  such  property  or  on  its  fair  market  price  or  value 
as  of  March  i,  1913,  if  acquired  prior  thereto.  In  the  absence 
of  proof  to  the  contrary,  it  will  be  assumed  that  such  value  as 
of  March  I,  1913,  is  the  cost  of  the  property,  less  depreciation 
up  to  that  date." 

Rates  of  Depreciation.  (Reg.  No.  33,  1918,  1[  485.)  "No 
definite  rate  has  been  fixed  by  which  an  allowable  deduction 
on  account  of  depreciation  in  the  value  of  any  class  of 
property  subject  to  wear  and  tear  is  tovbe  computed,  but  it  is 
contemplated  that  this  allowance  shall  be  computed  upon  the 
basis  of  the  cost  of  the  property  and  the  probable  number  of 
years  constituting  its  life.  The  deduction  to  be  allowed  relates 
solely  to  loss  due  to  use,  wear  and  tear,  and  the  matter  of  ob- 


156  PUBLIC  ACCOUNTING  AND  AUDITING 

solescence  is  not  relevant,  inasmuch  as  when  the  property  be- 
comes obsolete  a  deduction  for  the  loss  sustained  thereby,  repre- 
senting the  difference  between  the  cost  and  the  amount  of  de- 
preciation previously  charged  off  or  which  should  have  been 
charged  off  in  prior  years  will  be  allowed." 

It  will  therefore,  be  noted  that  the  law  makes  no  reference 
to  definite  rates  of  depreciation.  Neither  does  the  Treasury 
Department  specify  rates  which  shall  be  considered  satisfactory. 
The  law  merely  specifies  that  the  depreciation  allowances  shall 
be  "reasonable." 

REVIEW  OF  THE  LAW  OF  CONTRACTS 

As  to  time  of  performance,  contracts  may  be  divided  into 
two  classes— EXECUTORY  and  EXECUTED. 

A  contract  is  said  to  be  executory  when  some  condition 
remains  to  be  performed.  It  is  an  engagement  to  do  or  not 
to  do  a  particular  thing.  All  contracts  are  or  have  been  executory. 

A  contract  is  said  to  be  executed  when  all  the  conditions 
have  been  performed  and  nothing  remains  to  be  done.  An 
unpaid  note  is  an  example  of  an  executory  contract,  but  when 
paid  it  becomes  an  executed  contract. 

The  chart  on  page  62  of  Chapter  Five  shows  that  a  contract 
may  be  discharged  "by  performance."  When  all  the  conditions 
to  a  contract  have  been  performed  the  contract  is  discharged. 
These  conditions  may  be  classified  according  to  the  time  at  which 
they  should  be  performed,  and  are  known  as  (a)  PRECEDENT 
CONDITIONS,  (b)  CONCURRENT  CONDITIONS,  and  (c) 
SUBSEQUENT  CONDITIONS. 

A  Condition  Precedent  exists  when  some  condition  must 
be  performed  by  one  party  before  the  other  party  becomes  obli- 
gated to  perform  his  part  of  the  contract,  or  when  some  con- 
dition must  be  performed  before  a  contract  exists. 

A  Condition  Concurrent  exists  when  a  condition  must  be 
performed  by  one  party  at  the  same  time  that  the  other  party 
is  required  to  perform  some  other  condition  of  the  same  contract. 
The  one  party  must  perform  or  offer  to  perform  the  conditions 
imposed  by  the  contract,  at  the  time  the  demand  for  perfor- 
mance is  made  upon  the  other  party.  Otherwise,  the  other 
party  cannot  be  said  to  have  committed  a  breach. 

A  Condition  Subsequent  exists  when  the  occurrence  of  some 
fact  will  destroy  the  contract  in  the  event  it  happens,  provided 
the  parties  have  expressly  agreed  thereto. 

Sunday  Contracts.  Contracts  made  on  Sunday  are  void 
or  at  least  unenforceable  under  statute  law  in  practically  all  the 
states.  Statute  law  forbids  work,  labor  or  business  on  Sunday, 
unless  it  can  be  shown  that  they  relate  to  works  of  mercy,  charity 
or  necessity.  Examples  of  Sunday  contracts  which  are  usually 


THEORY  QUESTIONS  157 

enforceable,  are  such  as  the  providing  of  food  or  medicine  in 
cases  of  emergency  or  for  the  performance  of  services  under 
unavoidable  physical  conditions  which  would  entail  serious  loss 
or  injury  if  deferred.  However,  contracts  made  on  Sunday  and 
ratified  on  a  "business"  day  or  contracts  delivered  on  a  "business" 
day  and  to  take  effect  from  delivery  and  not  from  execution  are 
good  and  enforceable.  Contracts  or  agreements  are  illegal  which 
are  entered  into  on  Sunday  to  be  performed  on  a  week  day, 
or  which  are  entered  into  on  a  week  day  to  be  performed  on  a 
Sunday. 

Contracts  by  Correspondence.  An  offer  may  be  made 
by  mail,  or  by  telegraph,  as  well  as  in  person  or  through  an  agent 
or  representative.  It  may  be  accepted  in  the  same  manner 
unless  the  offer  specifies  the  method  of  acceptance.  An  offer 
may  be  conditional  and  one  of  the  conditions  may  relate  to  the 
method  of  acceptance  in  which  case  the  condition  must  be  com- 
plied with.  In  fact,  all  the  conditions  of  an  offer  must  be  accepted 
before  a  contract  is  made.  In  other  words,  an  acceptance  must 
be  unconditional. 

A  person  who  offers  to  contract  is  known  as  the  offerer, 
and  the  person  to  whom  an  offer  is  made  is  known  as  the  offeree. 
The  offeror  may  specify  the  time  in  which  an  offer  must  be 
accepted,  otherwise  the  offer  must  be  accepted  within  a  reason- 
able time.  An  offer  made  by  letter  or  telegraph  may  be  with- 
drawn by  a  subsequent  communication  provided  it  reaches  the 
offeree  before  he  has  accepted. 

As  soon  as  the  acceptance  is  placed  in  the  hands  of  the 
telegraph  company  or  mailed,  a  contract  exists.  That  is,  when 
the  letter  has  been  mailed,  or  has  been  dispatched  by  the  tele- 
graph company,  and  cannot  be  withdrawn.  If  the  acceptance  is 
not  made  by  the  same  method  as  the  offer,  then  the  contract 
does  not  exist  until  acceptance  is  received.  The  carrier  is  the 
agent  of  the  offeror  and  is  responsible  to  him  for  the  delivery 
of  the  acceptance. 

A.    THEORY  QUESTIONS 

1.  What  is  depreciation?     What  items  in  a  business  are 
subject  to  depreciation?    How  is  it  ascertained?     C.  P.  A.  Ark. 

2.  Name   three  methods   of  computing  depreciation   on 
machinery,  buildings,  etc.      How  should  such  depreciation  be 
shown  on  the  Balance  Sheet?  C.  P.  A.  Ohio 

3.  A  corporation  makes  a  practice  of  charging  to  expense 
and  carrying  to  depreciation  reserve  account  every  half  year, 
a  certain  percentage  of  the  book  value  of  its  plant  and  machinery. 

Should  repairs  and  renewals  be  charged  to  Profit  and  Loss, 

or  can  they  properly  be  charged  to  depreciation  reserve  accounts? 

Give  reasons  in  full.  C.  P.  A.  Mass. 


158  PUBLIC  ACCOUNTING  AND  AUDITING 

4.  How  should  a  re-appraisal  of  capital  assets  be  treated 
on  the  books  of  a  going  concern. 

(a)  When  it  involves  an  appreciation? 

(b)  When  it  involves  a  depreciation? 

Is  such  appreciation  or  depreciation  a  consideration  which 
should  be  reflected  in  a  return  of  net  income  to  the  federal 
authorities  for  income  and  excess -profits  tax  purposes? 

Inst.  Ex.  1918. 

5.  Give  some  general  principles  which  will  guide  you  in 
determining  whether  too  much  or  too  little  provision  has  been 
made  for  depreciation  of  buildings,  machinery,  tools,  goodwill, 
patents,  franchises,  etc.     Would  a  flat  rate  cover  all  these  assets 
satisfactorily?  Inst.  Ex.  1918. 

6.  You  are  asked  by  a  client  to  discuss  with  him  the  ques- 
tion of  reserves  for  depreciation  and  depletion  of  his  various 
capital  assets.     State  your  position  on  this  subject  and  enum- 
erate the  consideration  you  would  advance  in  support  thereof. 
Would  you  or  would  you  not  be  guided  by  the  rules  laid  down 
by  the  internal  revenue  authorities  in  deciding  the  rates  to 
be  used?  Inst.  Ex.  1918. 

7.  Explain  the  relationship  between  a  sinking  fund  and 
an  allowance  for  depreciation.     It  is  claimed  that  in  municipal 
enterprises  the  requirement  that  rates  must  be  high  enough  to 
provide  both  for  a  sinking  fund  to  pay  off  the  bonds  and  also 
for  a  "Reserve  for  Depreciation"  with  which  to  replace  the  plant 
results  in  a  double  charge  to  consumers.     Criticize  or  explain 
this  theory.  Inst.  Ex.  1917. 

8.  On  pointing  put  the  insufficiency  of  the  provision  for 
depreciation  on  machinery,  which  the  directors  admit,  you  are 
met  with  the  argument,  supported  by  evidence,  that  the  real- 
estate  values  have  appreciated  to  an  even  greater  extent  than 
the  entire  depreciation  of  other  assets.     As  this  latter  is  not 
taken  up  on  the  books  you  are  asked  to  allow  the  one  to  offset 
the  other.     Give  reasons  for  your  agreement  or  disagreement. 

Inst.  Ex.  1918. 

B.    ACCOUNTING  PROBLEMS 

i.  The  officers  of  a  company  of  which  you  are  the  auditor 
elected  by  the  stockholders,  submit  to  you  for  audit  a  Balance 
Sheet  in  which  the  following  item  appears: 

Miscellaneous  reserves  (including  premium  on  stock)  $248, 
ooo.oo.  On  investigation  you  find  the  item  is  made  up  as  fol- 
lows : 

General  reserve $86,000.00 

Operating  reserves 6,000.00 

Provision  for  plant  depreciation 46,000.00 

Provision  for  amortization  of  leaseholds 40,000.00 

Provision  for  bad  debts 36,000.00 

Premium  on  capital  stock  sold 34,000.00 

$248,000.00 


ACCOUNTING  PROBLEMS  159 

What  recommendation  would  you  make  to  the  officers  and 
what  course  would  you  take  if  your  recommendation  were  not 
followed?  Inst.  Ex.  1917. 

2.  A  machine  costing  $10,000.00  was  estimated  to  have 
a  life  of  ten  years,  with  a  residual  value  of  $1,000.00.     At  the 
close  of  each  year  a  charge  of  $900.00  was  made  and  a  similar 
amount  credited     to  "reserve  for  depreciation."     Just  prior  to 
closing  the  books  at  the  end  of  the  tenth  year  the  machine 
was  discarded  and  sold,  bringing  $2,000.00,  and  a  similar  machine 
was  bought  costing  $15,000.00.     Give  the  journal  entries  that 
you  would  make  to  close  the  books  at  the  end  of  the  tenth 
year  in  order  to  cover  these  transactions  and  to  make  the  neces- 
sary adjustments.     Interest  is  not  to  be  calculated. 

Inst.  Ex.  1917. 

3.  You  are  an  auditor  engaged  by  a  corporation  to  audit 
their  accounts.    At  the  beginning  of  the  period  you  are  to  cover, 
the  following  statement  is  drawn  from  the  books: 

Capital $100,000.00 

Surplus i  ,000.00 

Accounts  Receivable $10,000.00 

Buildings  after  deducting  $5,000.00 

for  depreciation 35,000.00 

Machinery  after  deducting  $5,000.00  for 

depreciation 55,000.00 

Cash 500.00 

Stock  on  hand : 500.00      

$101,000.00     $101,000.00 

During  the  period  which  you  are  auditing,  you  find  buildings 
and  machinery  charged  with  $10,000.00  which  was  to  cancel 
the  entries  of  depreciation. 

The  entries  were  authorized  according  to  the  minute  book, 
but  not  entered  correctly  in  the  general  books.  Formulate  the 
necessary  entries  for  the  bookkeeper.  Explain  what  method  had 
been  used  in  recording  the  depreciation  previously  charged  off. 
Can  you  suggest  a  better  method?  Do  you  think  that,  under 
any  circumstances,  it  is  wise  to  charge  the  depreciation,  previous- 
ly charged  off,  back  to  the  asset  accounts?  Explain  fully. 

C.  P.  A.  Mich. 

.    4.     In  your  examination  of  the  Automobile  Delivery  Truck 
account  of  a  company,  you  find  the  following  entries: 

AUTOMOBILE  TRUCKS 


1914 

Jan.    I  Trucks  I,  2, 

3,  4,  @  $1200.     $4,800.00 

July   i  Trucks 1,500.00 

Aug.  I  Truck  6 1.500.00 

$7,800.00 


1914 

Aug.     i  Truck  2 ....  $    900.00 

Sept.    i  Truck  4. ...       750.00 

i  Balance....  6,150.00 

$7,800.00 


I6o  PUBLIC  ACCOUNTING  AND  AUDITING 

The  reserve  for  Depreciation  for  Automobile  Delivery  Truck 
account  stood  credited  on  January  I,  1914,  with  $1,800.00. 

Upon  analyzing  the  transactions  represented  by  these  items 
you  find  the  following  facts : 

(a)  Truck  5  purchased  July   i   replaced  Truck  I.     The 
portion  of  the  reserve  for  depreciation  accumulated  on  January 
I  for  Truck  I  amounted  to  $900.00.     Truck  5  was  purchased 
on  open  account. 

(b)  Truck  2  was  traded  in  for  $850.00  on  the  purchase  of 
Truck  6  costing  $1,500.00.     The  difference  was  paid  in  cash. 
The  reserve  which  had  been  accumulating  for  depreciation  on 
Truck  2  on  January  i ,  amounted  to  $300.00. 

(c)  Truck  4  was  totally  destroyed  in  an  accident  Sept.  i . 
The  reserve  for  depreciation  on  this  truck  amounted  on  January 
I  to  $300.00. 

Assume  the  rate  of  depreciation  to  be  25%  per  year. 

Give  journal  entries  which  would  properly  record  the  above 
facts  and  show  the  balances  of  all  accounts  affected,  as  of  Sept- 
ember i,  1914.  .  C.  P.  A.  Mich. 

(Note.  You  are  not  asked  to  make  correcting  entries  for  those  already 
on  the  books  but  you  are  asked  to  make  entries  which  will  properly  record 
the  transactions. 

Be  sure  to  charge  Operating  Expense  and  credit  the  Reserve  for  De- 
preciation account  for  the  amount  of  depreciation  from  Jan.  I,  1914,  to  the 
date  of  the  transaction.  This  should  be  done  before  recording  the  transaction. 

In  order  to  determine  the  proper  balance  of  the  Reserve  for  Depre- 
ciation account  on  Sept.  I,  1914,  it  will  first  be  necessary  to  set  up  the  de- 
preciation on  trucks  3,  5  and  6.) 

C.    LEGAL  QUESTIONS 

(Note.  The  following  questions  are  all  taken  from  examinations 
held  by  the  American  Institute  of  Accountants  and  are,  therefore,  of  the 
highest  professional  standard.  They  are  given  as  a  review.) 

1.  When  can  an  offer  to  perform  a  contract  be  withdrawn? 

2.  What  is  a  tender  to  perform  a  contract  and  what  are 
its  effects? 

3.  (a)  Define  mistake  and  give  its  effect  on  contracts, 
(b)  Define  misrepresentation  and  state  its  effect. 

4.  "When  may  a  creditor  enforce  a  contract  with  a  minor? 

5.  A,  in  New  York  City,  wrote  B,  in  Buffalo,  offering 
certain  goods  for  sale  at  a  certain  price.     B  wrote  a  letter  to 
A  accepting  the  offer  and  posted  in  Buffalo.    Before  A  received 
the  letter  he  received  a  telegram  from  B  stating  that  he  with- 
drew the  acceptance.     Was  a  valid  contract  made?     Explain 
the  principles  involved.      ^j 

" 


Chapter  Eleven 


CURRENT  LIABILITIES 

Liabilities  are  the  financial  obligations  of  a  firm.  They  may 
be  divided  into  two  principal  classes,  Current  and  Fixed. 

Current  liabilities  are  those  obligations  that  mature  in  a 
short  period  of  time.  They  are  usually  undergoing  a  constant 
change.  There  should  be  sufficient  current  assets  owned  by  a 
firm  that  may  be  realized  upon  quickly,  if  necessary,  in  order 
to  liquidate  the  maturing  current  liabilities.  It  is  in  this  con- 
nection, a  banker  is  always  concerned,  when  considering  a 
request  for  a  loan.  The  current  liabilities  may  be  divided  into 
four  classes — unsecured,  secured,  contingent  and  accrued  lia- 
bilities. 

A  Balance  Sheet  audit  for  credit  purposes  is  more  concerned 
with  the  current  liabilities  than  with  the  fixed  liabilities.  The 
banker  does  not  extend  credit  to  merchandising  or  trading  con- 
cerns with  the  view  of  furnishing  additional  capital,  but  rather 
to  enable  them  to  carry  a  large  stock-in-trade  during  a  busy 
season,  or  to  enable  them  to  discount  their  accounts  payable  at 
a  time  when  the  company's  quick  assets  are  composed  largely 
of  stock-in-trade  and  accounts  receivable. 

Banks  advance  money  on  short  time  or  call  loans  and, 
naturally,  the  current  assets  of  the  borrowing  company  must 
be  such  that  it  is  apparent  sufficient  funds  may  be  realized  to 
liquidate  all  current  liabilities. 

Of  course,  the  auditor  must  satisfy  himself  that  all  the  fixed 
liabilities  are  properly  stated,  otherwise  he  could  not  certify  as 
to  the  actual  financial  condition  of  the  business. 

ACCOUNTS  PAYABLE 

Accounts  payable  appear  in  the  Balance  Sheet  as  current 
liabilities.  Different  terms  are  applied  to  these  accounts,  such 
as  Purchases  Ledger  accounts,  Creditors'  accounts,  Vouchers 
Payable,  etc. 

1.    ACCOUNTING  THEORY 

Accounts  with  Creditors.  These  accounts  may  be  kept 
in  the  general  ledger,  but  it  is  customary  to  keep  only  a  con- 
trolling account  in  the  general  ledger  and  to  keep  the  individual 
accounts  in  a  subsidiary  ledger,  known  as  a  purchases  ledger  or 
creditors'  ledger. 

161 


162  PUBLIC  ACCOUNTING  AND  AUDITING 

The  Purchases  Ledger.  It  is  important  that  only  ac- 
counts payable  for  purchases  be  recorded  in  this  ledger.  These 
accounts  should  represent  trade  creditors.  Liabilities  on  ac- 
count of  accrued  interest,  taxes,  wages,  etc.,  should  appear  in 
the  Balance  Sheet  as  separate  items  and  should  not  be  included 
with  accounts  payable. 

The  Purchases  Ledger  Controlling  Account.  When  a 
separate  ledger  is  kept  with  accounts  payable,  a  controlling 
account  should  be  kept  in  the  general  ledger  and  the  balance  of 
the  controlling  account  should  show  the  same  results  as  the  total 
of  the  balances  of  accounts  in  the  subsidiary  ledger.  The  pur- 
pose of  this  controlling  account  is  to  make  the  general  ledger 
self-balancing  and  to  enable  the  general  ledger  bookkeeper  to 
prepare  a  Trial  Balance  from  the  general  ledger  without  the 
necessity  of  first  ascertaining  the  balances  of  all  the  individual 
accounts  payable.  It  also  separates  the  work  of  the  book- 
keepers and  by  planning  the  work  so  that  the  individual  ledger 
bookkeeper  does  not  have  access  to  the  general  ledger,  it  will 
constitute  an  internal  check  on  his  work. 

To  establish  a  subsidiary  purchases  ledger  and  a  controlling 
account  for  same  in  the  general  ledger,  assuming  that  the  ac- 
counts with  creditors  have  previously  been  kept  in  the  general 
ledger,  make  a  journal  entry  as  follows: 

Accounts  with  Creditors xxxxx.xx 

Purchases  Ledger  Controlling  Acct .  .  xxxxx .  xx 

To  establish  a  subsidiary  ledger  for  accounts 
with  creditors.    See  schedule  following: 

Each  creditor's  account  in  the  general  ledger  is  debited  with 
the  amount 'shown  in  the  schedule  and  should  then  balance. 
After  posting  the  total  amount  of  accounts  payable  to  the  credit 
of  the  controlling  account,  each  individual  account  in  the  pur- 
chases ledger  should  be  credited  with  the  proper  amount  as 
shown  in  the  schedule.  After  the  entry  has  been  properly  posted, 
the  balance  of  the  controlling  account  will  equal  the  total  of 
the  balances  of  the  accounts  in  the  purchases  ledger. 

After  the  purchases  ledger  has  been  opened  and  the  accounts 
all  transferred  from  the  general  ledger,  these  accounts  will  be 
debited  and  credited  from  the  books  of  original  entry  in  the 
usual  manner.  However,  special  columns  will  usually  be  cre- 
ated in  the  original  books  of  account  so  that  only  the  totals  of 
these  columns  need  be  posted  to  the  controlling  account  in  the 
general  ledger. 

The  Voucher  System.  One  frequently  hears  of  the 
voucher  system  of  bookkeeping.  As  a  matter  of  fact  it  is  not 
a  system  of  bookkeeping  at  all,  but  is  a  method  of  recording 
invoices  representing  all  expenditures  incurred,  whether  for 
material,  labor,  indirect  expenses,  selling  expenses,  adminis- 
trative expenses,  and  even  for  additions  to  the  plant,  equipment, 
etc. 


THE  VOUCHER  SYSTEM  163 

It  is  said  to  be  a  combination  of  the  purchases  book  and 
the  purchases  ledger,  but  this  is  rather  an  exaggeration.  It  is 
true,  however,  that  with  the  voucher  system  in  use,  it  is  cus- 
tomary to  dispense  with  the  purchases  ledger.  In  fact,  this  is 
the  means  of  its  representing  a  considerable  saving  of  time.  There 
is  also  a  saving  in  time  in  the  distribution  of  the  various  charges 
to  materials  and  expenses. 

The  Voucher  Jacket.  Every  invoice  received,  after  being 
approved  for  receipt  of  goods,  prices,  and  extensions,  might  be 
marked  with  the  names  of  the  accounts  to  be  charged  and  the 
amount  chargeable  to  each.  The  invoice  might  also  be  given 
a  number  from  the  voucher  register.  It  can  readily  be  seen 
that  to  indicate  all  this  information  on  the  invoice  itself  would 
be  anything  but  good  practice.  Therefore,  it  is  customary  to 
use  a  form  especially  prepared  for  this  purpose.  This  form  is 
called  a  voucher  jacket  or  an  accounts  payable  voucher.  It 
provides  for  recording  the  number  of  the  voucher,  name  of  the 
creditor,  date,  amount,  and  classification  of  the  items  listed  in 
the  invoice  for  which  the  form  is  made.  There  is  also  pro- 
vision for  information  as  to  the  date  and  method  of  payment. 
The  names  of  the  accounts  most  frequently  affected  are  printed 
on  the  form  so  as  to  save  time  and  facilitate  proper  classifica- 
tion. 

The  Voucher  Register.  This  book  contains  columns  for 
the  voucher  number,  date  of  invoice,  date  and  method  of  pay- 
ment, vouchers  payable  credit,  and  a  series  of  money  columns 
for  the  various  accounts  to  be  debited.  A  sundry  column  is 
provided  for  unusual  accounts.  After  the  invoice  is  received 
and  has  been  approved,  it  is  placed  in  the  voucher  jacket  or 
attached  to  the  accounts  payable  voucher,  often  together  with 
the  purchase  requisition,  purchase  order,  and  material  received 
sheet  and  is  then  recorded  in  the  voucher  register  and  properly 
filed  with  the  unpaid  vouchers,  usually  under  its  due  date. 
When  the  invoice  becomes  due  it  is  removed  from  the  file  and 
after  the  check  has  been  written,  it  is  recorded  on  the  voucher 
jacket  or  accounts  payable  voucher  and  then  filed  among  the 
paid  vouchers.  Of  course,  a  memorandum  is  made  in  the 
voucher  register  showing  date  and  method  of  payment.  This 
check  is  then  recorded  in  the  cash  book  where  a  special  column 
for  vouchers  payable  is  provided  for. 

The  Vouchers  Payable  Controlling  Account.  This 
account  takes  the  place  of  the  Purchases  Ledger  Controlling 
account  and  is  in  itself  a  controlling  account  for  vouchers  pay- 
able. This  account  is  credited  for  the  total  of  the  vouchers 
payable  column  in  the  voucher  register  and  is  debited  for  the 
total  of  the  vouchers  payable  column  in  the  cash  book.  The 
balance  of  the  account  represents  a  current  liability.  When 
all  invoices  have  been  paid  the  account  will  balance.  The 
balance  of  this  account  may  be  verified  by  preparing  a  list  of 
the  unpaid  vouchers. 


164  PUBLIC  ACCOUNTING  AND  AUDITING 

The  advantages  of  this  system  have  already  been  pointed 
out.  No  purchases  or  creditors'  ledger  is  required.  Most'of 
the  expense  accounts  need  be  posted  but  once  a  month  and  then 
the  total  only  is  posted  from  the  voucher  register.  The  voucher 
jacket  may  contain  a  complete  history  of  the  purchase  trans- 
actions from  the  time  the  requisition  is  made  until  the  check 
issued  in  payment  therefor  has  been  cancelled  and  returned 
from  the  bank. 

On  the  other  hand,  the  system  has  its  disadvantages.  Par- 
tial payments  on  invoices,  that  is,  payments -on  account,  are 
practically  impossible.  Furthermore,  this  system  does  not 
readily  show  the  total  present  balance  due  a  given  creditor, 
neither  does  it  show  the  total  amount  of  business  done  with  a 
creditor  for  a  given  period.  Of  course,  ledger  accounts  with 
individual  creditors  might  be  kept  in  connection  with  the  voucher 
system,  but  in  this  event  the  saving  in  time,  for  which  the  sys- 
tem is  noted,  would  be  lost.  Under  certain  conditions  the 
voucher  system  may  be  used  advantageously,  but  under  other 
conditions  its  use  is  often  burdensome.* 

Classification  of  Accounts  Payable  in  Balance  Sheet. 

The  Federal  Reserve  Board  requires  that  the  accounts  payable 
be  divided  and  classified  in  the  Balance  Sheet  under  unsecured 
accounts  as  follows: 

Accounts  Payable  for  Purchases  (not  yet  due) xxxxx .  xx 

Accounts  Payable  for  Purchases  (past  due) xxxxx .  xx 

Accounts    Payable    to    Stockholders,    Officers,    or 

Employees xxxxx.  xx 

(See  Model   Balance  Sheet  for  credit  purposes,  page  41, 
Chapter  Three.) 

2.    AUDITING  THEORY. 

Quoting  from  the  Federal  Reserve  Bulletin  on  Uniform 
Accounting: 

Verifying  Accounts  Payable.  "A  list  of  balances  due 
on  open  accounts  must  be  prepared  and  carefully  checked  with 
the  ledger  accounts,  care  being  taken  to  see  that  no  open  account 
on  the  ledger  has  been  omitted  from  the  list.  It  should  be  ascer- 
tained that  the  balances  represent  specific  and  recent  items 
only.  When  any  account  does  not  appear  regular,  a  statement 
should  be  obtained  from  the  creditor.  If  there  are  many  such 
accounts  in  dispute,  and  they  amount  to  so  large  a  sum  as  to 

(*Note.  In  this  discussion  of  the  voucher  method  for  handling 
invoices,  there  has  been  no  attempt  to  explain  the  many  variations  of  the 
systems  that  will  be  encountered  in  practice.  It  has  not  been  considered 
necessary  to  illustrate  the  different  forms  and  ruling  of  the  books  used  as  these 
are  shown  in  any  bookkeeping  text  that  is  at  all  up-to-date.  We  refer  you  to 
"2Oth  Century  Bookkeeping  and  Accounting,"  Part  IV,  for  a  complete  dis- 
cussion of  all  the  principles  involved  and  for  illustrations  of  the  voucher 
jacket,  voucher  check  and  vouchers  payable  book.  Similar  information 
should  be  obtainable  from  any  standard  text  on  bookkeeping  and  accounting.) 


ACCOUNTS  PAYABLE  165 

affect  appreciably  the  total  of  current  liabilities,  the  general 
causes  for  the  disputes  should  be  inquired  into  and  note  made 
of  the  matter  for  the  consideration  of  the  banker. 

Voucher  Systems.  "In  concerns  with  modern  voucher 
systems  accounts  payable  are  easily  verified,  as  all  liabilities 
are  then  included  in  the  books  when  incurred.  Care  should  be 
taken,  however,  to  see  that  all  goods  received  on  the  last  day 
of  the  fiscal  period,  as  shown  by  the  receiving  records,  and  also 
all  goods  that  were  in  transit  and  belonged  to  the  concern  on 
that  date,  are  included  as  liabilities,  and  the  corresponding 
assets  included  in  the  inventories.  This  test  is  necessary,  as  an 
increase  in  the  accounts  payable  may  have  a  very  important 
bearing  on  the  financial  position  of  the  concern  if  the  cash  on 
hand  is  small. 

"Monthly  expenses  outstanding  can  usually  be  ascertained 
by  a  comparison  of  the  expenses  of  the  last  month  of  the  fiscal 
period  with  previous  months,  and  those  of  the  year  with  the 
previous  year.  The  voucher  record  should,  however,  be  ex- 
amined for  the  months  subsequent  to  the  close  of  the  fiscal  year, 
in  case  any  expenses  included  therein  are  applicable  to  the  fiscal 
period  under  audit. 

Detecting  Unstated  Liabilities.  "When  a  first-class 
voucher  system  is  not  in  operation,  the  auditor  must  take  addi- 
tional precautions  to  satisfy  himself  that  all  liabilities  are  in- 
cluded in  the  accounts,  among  which  may  be  mentioned: 

"(i)  Payments  made  in  the  months  subsequent  to  the 
date  of  the  fiscal  period  as  shown  by  the  cash  book,  which  should 
be  carefully  scrutinized  to  see  that  none  of  them  is  applicable 
to  the  period  under  review. 

"(2)  The  file  of  bills  not  vouchered  or  entered  on  the 
books  should  be  examined  to  see  that  none  of  them  belongs  to 
the  period  under  audit. 

"(3)  A  careful  perusal  of  the  minutes  of  a  company  may 
further  assist  the  auditor  in  determining  liabilities. 

Purchase  Contracts.  "When  a  company  has  large  pur- 
chase contracts  in  force  for  future  deliveries  they  should  be  ex- 
amined, for  if  the  contract  prices  are  greater  than  market  prices, 
it  might  be  necessary  to  set  up  a  reserve  for  this  loss.  Any 
debit  balance  due  to  advance  payments  on  such  contracts  or  to 
any  other  cause  should  be  shown  on  the  Balance  Sheet  under 
a  separate  heading. 

Consignment  Purchases.  "If  the  business  under  audit 
is  one  where  there  is  any  possibility  of  goods  having  been  re- 
ceived on  consignments,  and  part  or  all  of  such  goods  having 
been  sold  without  a  liability  therefor  having  been  shown  in  the 
books,  the  auditor  must  use  all  due  diligence  to  cover  the  point 
fully.  This  may  readily  happen,  as  consignment  accounts  are 
usually  treated  as  memoranda  only. 


166  PUBLIC  ACCOUNTING  AND  AUDITING 

"If  inquiry  develops  the  fact  that  goods  have  been  received 
on  consignment,  all  records  in  connection  therewith  should  be 
called  for.  If  the  goods  have  all  been  sold,  the  consignor's  ac- 
count should  show  the  full  amount  due,  and  if  the  debt  is  a 
current  one,  the  amount  will  appear  among  accounts  payable 
due  to  trade  creditors.  Where  only  part  of  the  goods  have  been 
sold,  the  net  proceeds  due  to  the  consignors  should  be  shown 
on  the  Balance  Sheet  under  the  caption  of  'Accounts  payable 
consignors.' 

Certificates.  "As  an  additional  precaution  against  the 
omission  of  liabilities,  a  certificate  should  be  obtained  from  the 
proper  officer  or  member  of  the  concern  stating  that  all  out- 
standing liabilities  for  purchases  and  expenses  have  been  in- 
cluded in  the  accounts  of  the  period  under  review  or  of  former 
periods.  In  many  cases  it  is  also  advisable  to  obtain  a  cer- 
tificate from  the  president  stating  that  all  liabilities  for  legal 
claims,  infringements  of  patents,  claims  for  damages,  bank 
loans,  etc.,  have  been  included,  as  he  may  be  the  only  executive 
officer  of  the  company  to  know  the  extent  of  such  obligations." 

NOTES  PAYABLE 

Notes  payable  are  usually  classed  as  current  liabilities  in 
the  Balance  Sheet.  Under  this  title  will  usually  be  included 
drafts,  notes  and  trade  acceptances.  There  need  be  no  attempt 
to  keep  separate  accounts  with  drafts  and  notes.  To  dp  so 
would  only  be  a  waste  of  time  for  the  information  given  is  of 
no  practical  value.  Some  bookkeepers  still  use  the  term  "bills 
payable."  This  matter  was  discussed  on  page  66  of  Chapter 
Five,  undei  the  heading  of  "Terminology." 

Mr.  Walton,  in  the  November,  1919  number  of  The  Journal 
of  Accountancy,  in  writing  upon  this  subject,  says: 

"The  accounting  profession  has  not  differentiated  as  yet 
between  notes  payable  and  bills  payable. 

"In  England  and  in  continental  Europe  drafts  or  bills  of 
exchange  have  been  a  more  customary  method  of  handling 
credit  transactions  than  notes  payable.  In  England,  where 
most  of  our  accounting  terminology  originated,  bills  of  exchange 
were  much  more  common  than  notes;  therefore,  they  used  the 
term  bills  payable  and  bills  receivable,  and  whenever  a  few  notes 
were  given  they  were  entered  in  the  account  with  the  bills. 

"In  this  country  the  custom  has  been  exactly  the  reverse. 
We  have  been  accustomed  to  giving  notes  rather  than  accept- 
ing bills  of  exchange;  but  we  have  used  the  English  terminology 
of  bills  payable  until  recent  times.  Realising  that  the  term 
bills  payable  was  not  as  appropriate  in  this  country  as  in  England, 
a  movement  has  been  on  foot  to  change  the  terminology  from 
bills  payable  to  notes  payable  and  this  movement  has  met  with 
considerable  success  so  that  the  term  notes  payable  rather  than 
bills  payable  now  frequently' appears  in  Balance  Sheets. 


NOTES  PAYABLE  167 

"Strictly  speaking  a  promissory  note  is  a  note  payable; 
a  trade  acceptance  is  a  bill  payable;  but  I  am  inclined  to  think 
that  as  trade  acceptances  become  more  prevalent  they  will  be 
recorded  in  a  Trade  Acceptance  account  rather  than  a  Bills 
Payable  account. 

"The  statement  that  notes  payable  should  always  bear 
interest  is  not  correct.  Interest  is  an  immaterial  detail  which 
may  be  found  in  a  bill  of  exchange  or  trade  acceptance  as  well 
as  in  a  note  and  is  not  essential  to  either.  In  an  accounting  sense, 
bills  payable  are  always  notes  or  acceptances  payable  at  a  future 
date,  and  the  term  does  not  include  cheques  or  sight  drafts. 

"The  objection  to  the  term  bills  payable  is  that  in  this 
country  many  business  men  not  being  accustomed  to  bills  of 
exchange  think  the  term  refers  to  the  bills  rendered  by  their 
creditors  which  are  payable  every  month." 

1.    ACCOUNTING  THEORY 

Recording  Notes  Payable  in  Original  Books  of  Account. 

Like  notes  receivable,  there  are  two  principal  methods  of  record- 
ing drafts  and  notes.  The  first  method  is  to  record  them  in  the 
general  journal  and  to  keep  a  memorandum  record  in  an  auxil- 
iary notes  payable  book.  This  memorandum  record  does  not 
constitute  a  posting  medium  as  all  posting  would  be  done  from 
the  journal.  The  notes  payable  book  should  provide  columns 
showing  date  given,  number,  drawer  or  endorser,  maker  or 
drawee,  payee,  where  payable,  due  date,  amount,  rate  of  in- 
terest and  when  paid. 

Notes  Payable  Book  as  a  Posting  Medium.  The  second 
method  is  to  record  drafts  and  notes  in  a  notes  payable  book 
instead  of  the  journal  and  so  arranging  the  record  that  it  not 
only  shows  a  complete  record  of  the  drafts  and  notes,  but  also 
constitutes  a  posting  medium.  In  addition  to  all  the  columns 
mentioned  under  the  first  method  described  above,  there  should 
also  be  columns  provided  to  enable  the  bookkeeper  to  post  the 
totals  to  the  proper  accounts  in  the  ledger.  This  may  vary 
somewhat  depending  upon  the  particular  system  of  accounts 
in  use,  but  usually  there  will  be  columns  headed  notes  payable 
credit,  interest  debit,  interest  credit,  purchases  ledger  debit  and 
general  ledger  debit. 

Notes  Payable  Account.  This  account  may  show  indi- 
vidual entries  for  each  note  and  draft  recorded  in  the  books  of 
account.  However,  if  the  second  method  for  recording  notes 
is  followed,  then  this  account  will  be  a  summary  account.  It 
will  be  credited  for  the  total  of  the  notes  payable  column  in  the 
notes  payable  book  and  will  be  debited  for  the  total  of  the  notes 
payable  column  on  the  credit  side  of  the  cash  book.  If  no  spe- 
cial column  is  provided  in  the  cash  book,  then  it  will  be  debited 
for  the  individual  notes  recorded  therein. 


168  PUBLIC  ACCOUNTING  AND  AUDITING 

Trade  Acceptances  Payable.  Trade  acceptances  receiv- 
able were  discussed  on  page  66  of  Chapter  Five.  The  method  of 
recording  trade  acceptances  payable  should  be  similar  to  that  for 
recording  trade  acceptances  receivable.  Reference  to  the  Model 
Balance  Sheet  for  credit  purposes  on  page  41  of  Chapter  Three 
will  show  that  acceptances  made  for  merchandise  and  raw 
material  should  be  stated  separately.  Therefore,  it  will  readily 
be  seen  that  if  a  separate  account  is  kept  in  the  general  ledger, 
it  will  not  be  necessary  to  analyze  the  Notes  Payable  account 
to  determine  this  information.  If  a  separate  account  is  kept, 
it  will  either  be  necessary  to  record  them  in  the  general  journal 
or  provide  a  special  trade  acceptances  book  similar  to  the  notes 
payable  book  described  under  the  second  method  on  page  167 
of  this  chapter. 

Classification  of  Notes  Payable.  In  preparing  a  state- 
ment for  credit  purposes,  the  Federal  Reserve  Board  requires 
that  notes  payable  be  classified  in  the  Balance  Sheet  as  follows: 

1.  Notes  given  for  merchandise  or  raw  ma- 

terial purchased xxxxx.xx 

2.  Notes  given   to  banks  for  money  bor- 

rowed     xxxxx . xx 

3.  Notes  sold  through  brokers xxxxx.xx 

4.  Notes  given  for  machinery,  additions  to 

plant,  etc xxxxx.xx 

5.  Notes  due  to  stockholders,   officers,   or 

employees xxxxx.xx 

These  are  known  as  "unsecured  liabilities."  Notes  and 
accounts  payable,  secured  by  liens  on  inventories,  or  by  securi- 
ties deposited  as  collateral,  should  be  stated  separately  as 
"secured  liabilities."  (See  page  41  of  Chapter  Three.) 

2.    AUDITING  PROCEDURE 

Quoting  from  Federal  Reserve  Bulletin  on  Uniform  Ac- 
counting: 

"Under  this  caption  appear  notes  payable  and  drafts 
accepted.  Schedules  should  be  prepared  under  the  subcaptions, 
and  in  columns  headed: 

'Date  of  making  the  notes  or  drafts. 
'Due  dates. 
'Names  of  creditors. 
'Collateral  hypothecated. 
'Additional  endorsers. 
'Interest  accrued  to  date  of  audit. 
'Notations   of  renewals    (as   information   of   this 
nature  furnishes  a  guide  to  the  state  of  the 
concern's  credit.) 

"The  schedule  must  be  compared  with  the  notes  payable 
book  and  the  total  of  the  aggregate  must  agree  with  the  balance 
of  the  ledger  account  of  notes  payable. 


CONTINGENT  LIABILITIES  169 

"Statements  must  be  obtained  from  all  banks  and  brokers 
with  whom  the  concern  does  business,  showing  all  notes  and 
drafts  discounted  or  sold  by  them  for  the  benefit  of  the  con- 
cern. These  statements  when  received  must  be  checked  against 
the  loans  shown  on  the  concern's  books  and  approved  in  the 
minutes  of  the  company. 

"Inasmuch  as  a  note  is  a  negotiable  instrument,  care  must 
be  taken  to  see  that  all  of  those  recorded  as  paid  during  the 
year  under  audit  have  been  properly  discharged,  and  the  can- 
celed notes  are  the  best  evidence  of  this  fact. 

"Careful  attention  should  be  given  to  the  collateral  depos- 
ited for  loans,  and  statements  as  to  the  existence  of  such  col- 
lateral should  be  obtained  from  the  holders  thereof.  Such 
hypothecation  of  any  of  the  concern's  assets  should  be  accounted 
for  on  the  Balance  Sheet. 

"When  practicable,  the  auditor  might  suggest  to  the  client 
the  advisability  of  drawing  notes  payable  on  blanks  bound  in 
a  book,  like  a  check  book,  with  a  stub  for  each  blank,  the  blank 
and  the  stub  to  bear  identical  numbers.  The  officer,  or  officers, 
signing  the  notes  could,  in  such  case,  initial  the  stub  as  a  cer- 
tificate to  the  amounts,  payees,  and  terms  of  the  notes  issued. 
If  this  were  done,  the  auditing  of  bills  payable  would  be  greatly 
facilitated." 

CONTINGENT  LIABILITIES 

It  has  previously  been  pointed  out  that  a  Balance  Sheet 
audit  involves  the  detection  of  all  unstated  liabilities  as  well  as 
verification  of  those  appearing  on  the  books  of  account.  The 
discovery  of  contingent  liabilities  is  not  a  simple  matter  and  is 
often  almost  impossible,  especially  where  an  attempt  has  been 
made  to  conceal  them. 

Many  an  individual  or  firm  has  suffered  a  loss  and  even 
became  bankrupt  because  of  being  compelled  to  meet  obliga- 
tions which  did  not  arise  out  of  the  usual  operation  of  business, 
obligations  which  did  not  in  any  case  appear  on  the  books  of 
account.  Almost  everyone  is  familiar  with  some  instance 
wherein  an  individual  or  firm  who  had  endorsed  a  note  only  as 
a  matter  of  accommodation,  and  later  through  unforeseen  cir- 
cumstances was  compelled  to  meet  it  because  of  the  inability 
or  failure  of  the  maker  to  do  so. 

The  author  recalls  an  experience  of  an  audit  of  a  manu- 
facturing company.  During  the  course  of  the  audit  we  learned 
that  another  company  had  brought  suit  on  the  basis  of  infringe- 
ment of  patent  rights.  This  company  had  purchased  certain 
patent  rights  costing  several  hundred  thousand  dollars  and 
had  set  up  the  cost  as  an  asset,  and  was  charging  this  off 
over  a  period  of  years  based  on  the  life  of  the  patents.  Further 
investigation  revealed  the  fact  that  the  result  of  the  suit  was 
quite  uncertain.  The  company  had  been  using  these  patented 
machines  for  several  years.  The  plaintiff  asked  for  damages 
based  on  the  total  production  of  the  machines.  We  called 


i?o  PUBLIC  ACCOUNTING  AND  AUDITING 

attention  to  this  action  in  our  report  and  advised  that  a  fund 
be  set  aside  out  of  profits  until  such  time  as  the  court  had  reached 
a  decision.  Several  months  later  our  client  lost  the  suit  and  was 
forced  to  pay  several  thousand  dollars  damages.  It  will  be  seen, 
therefore,  that  contingent  liabilities  are  likely  to  become  real  and 
an  auditor  must  be  very  careful  to  make  every  effort  to  detect 
them. 

Auditing  Procedure.  (Federal  Reserve  Bulletin.) 
"It  is  not  enough  that  a  Balance  Sheet  shows  what  must 
be  paid;  it  should  set  forth  with  as  much  particularity  as  pos- 
sible what  may  have  to  be  paid.  It  is  the  duty  of  an  auditor 
who  makes  a  Balance  Sheet  audit  to  discover  and  report  upon 
liabilities  of  every  description,  not  only  liquidated  debts  but 
possible  debts.  The  following  are  the  usual  forms  under  which 
contingent  liabilities  will  be  found: 

Endorsements.  "Inquiry  of  the  officers  or  partners  of 
the  concern  should  be  made  as  to  whether  any  endorsement 
of  outside  paper  has  been  made  and  as  to  any  security  received 
to  protect  the  concern.  Such  inquiry  should  be  particularly 
strict  if  it  is  known  that  any  of  the  officers  or  partners  are  inter- 
ested in  other  enterprises. 

Guaranties.  "Similar  action  should  be  taken  in  the  mat- 
ter of  guaranties. 

Unfulfilled  Contracts.  "Contracts  to  accept  the  delivery 
of  goods  contracted  for  before  the  date  of  the  Balance  Sheet, 
may  call  for  the  payment  of  large  sums  of  money  within  a  short 
time.  In  the  case  of  raw  materials,  for  a  manufacturer,  this 
might  be  a  perfectly  legitimate  reason  for  seeking  a  temporary 
loan  pending  production  and  sale,  but  for  a  merchant  whose 
Balance  Sheet  shows  a  large  stock  of  goods  on  hand,  it  might 
indicate  a  real  liability  impending  with  assets  of  a  doubtful 
character  to  offset  it.  In  every  audit,  therefore,  the  auditor 
should  call  for  copies  of  all  orders  for  future  delivery,  and  if 
such  orders  call  for  stock  in  excess  of  the  current  and  reason- 
able prospective  demand,  mention  should  be  made  on  the  Bal- 
ance Sheet  and  a  report  submitted,  the  details  depending  upon 
the  circumstances  of  each  particular  case. 

"Items  other  than  those  arising  from  the  specific  hypothe- 
cation of  current  assets  should  appear  as  a  footnote  on  the 
liability  side  of  the  Balance  Sheet,  the  total  amounts  being 
stated  for  each  subheading  and  such  additional  report  made  as 
will  convey  clear  information  to  the  banker." 

It  will  be  seen,  therefore,  that  there  are  two  different 
methods  for  classifying  contingent  liabilities.  Those  based  upon 
"specific  hypothecation  of  current  assets"  should  be  listed  on 
the  credit  side  of  the  Balance  Sheet  among  the  secured  liabili- 
ties. These  are  contra  entries  because  the  hypothecated  items 
also  appear  among  the  current  assets. 


ACCRUED  LIABILITIES  171 

Such  contingent  liabilities  as  accommodation  endorse- 
ments, actions  or  suits  pending  against  client,  guaranties,  etc., 
should  at  least  be  mentioned  in  a  footnote  on  the  liability  side 
of  the  Balance  Sheet  and  should  be  accurately  outlined  in  the 
report  to  the  client. 

ACCRUED  LIABILITIES 

All  accrued  liabilities  should  be  classed  as  current  liabilities 
in  the  Balance  Sheet.  These  are  not  difficult  to  ascertain  as 
they  can  be  accurately  determined  and  the  amount  calculated 
from  the  accounting  records. 

Auditing  Procedure.  (Federal  Reserve  Bulletin.) 
"Under  this  caption  are  grouped  such  items  as  interest, 
taxes,  wages,  etc.,  which  have  accrued  to  the  end  of  the  period 
under  audit,  but  are  not  due  and  payable  until  a  later  date. 
The  verification  of  such  items  can  be  accurately  made  from  the 
books  and  records.  Special  attention  may  be  directed  to  the 
following: 

Interest  Payable.  "Many  of  the  liabilities  which  appear 
on  a  Balance  Sheet  carry  interest.  Such  items  as  bonds  and 
notes  payable  are  obvious,  but  the  auditor  should  also  consider 
the  possibility  of  accounts  also  bearing  interest,  as  enough  book 
accounts,  when  past  due,  to  bear  interest  to  warrant  inquiry 
being  made.  Loan  accounts  of  partners  and  officers  of  corpora- 
tions almost  invariably  bear  interest;  also  judgments,  overdue 
taxes,  and  other  liens. 

Taxes.  "The  amount  of  accrued  State  and  local  taxes 
can  be  ascertained  from  an  examination  of  the  latest  tax  re- 
ceipts; though  in  some  cases,  as  the  period  for  which  the  taxes 
are  paid  is  not  shown  on  the  face  of  the  receipt,  it  may  be  neces- 
sary to  make  inquiries  of  the  proper  taxing  authorities  as  to  the 
period  covered. 

"Under  the  Federal  Income  Tax  Law  a  tax  is  imposed 
upon  the  net  profits  of  a  corporation,  which  must  be  paid  even 
if  the  corporation  is  dissolved  before  the  end  of  the  year  during 
which  the  tax  is  imposed.  As  the  tax  is  specifically  based  upon 
the  net  profits  of  a  particular  period,  although  payable  some 
months  thereafter,  the  tax  accrues  throughout  the  specified 
period,  and  if  a  net  profit  is  disclosed  upon  the  closing  of  the 
books  at  any  date  during  the  year,  a  reserve  equal  to  the  amount 
of  the  accrued  tax  must  be  shown  on  the  Balance  Sheet. 

Wages.  "Where  the  date  of  the  Balance  Sheet  does  not 
coincide  with  the  date  to  which  the  last  pay  roll  of  the  period 
under  audit  has  been  calculated,  the  amount  accrued  to  the 
date  of  the  Balance  Sheet  must  be  ascertained  and  entered  as 
a  liability,  unless  such  amount  is  trifling.  It  will  suffice  to  take 
the  proportion  of  a  full  week's  pay  roll  (six  days)  without  ref- 
erence to  possible  daily  variations. 


172  PUBLIC  ACCOUNTING  AND  AUDITING 

Water  Rates,  Etc.  "Where  bills  for  such  expenses  as 
water,  gas,  etc.,  are  not  rendered  monthly,  the  auditor  must 
enter  the  accrual  of  the  proper  proportion  since  the  last  bill  as 
a  liability. 

Traveling  Expenses  and  Commissions.  "It  is  important 
to  note  whether  the  accounts  of  all  traveling  salesmen  have 
been  received  and  entered  before  the  books  are  closed.  The 
auditor  should  secure  a  list,  and  if  any  report  was  not  so  entered, 
provision  should  be  made  for  it  unless  the  amount  is  likely  to 
be  trifling. 

"Ample  provision  should  be  made  for  all  commissions 
eventually  payable  on  sales  which  have  been  billed  to  customers. 
As  commissions  are  frequently  not  payable  to  salesmen  until 
the  sales  have  been  collected  from  the  customers,  accrued  com- 
missions are  often  omitted  from  the  books.  As  they  must, 
however,  be  paid  out  of  the  proceeds  of  the  sales  on  which  the 
full  profit  has  already  been  taken  into  the  accounts,  they  should 
be  set  up  as  an  accrued  liability. 

Legal  Expense.  "All  concerns  have  more  or  less  litiga- 
tion. Before  the  books  are  closed  the  lawyers  should  be  re- 
quested to  send  in  a  bill  to  date.  If  one  is  not  found,  the  auditor 
should  ascertain  the  amount,  if  any,  probably  due  and  set  it 
up  as  an  accrued  liability. 

Damages.  "If  the  concern  is  insured  against  liability  for 
damages  to  employees  or  the  public,  a  proportion  of  the  pre- 
miums paid  in  advance  for  the  unexpired  time  covered  by  the 
insurance  will  appear  in  'Deferred  charges.'  But  there  may  be 
claims  or  suits  for  other  damages  not  covered  by  insurance,  and 
where  the  auditor  finds  any  evidence  which  leads  him  to  suspect 
there  may  be  liability  of  this  nature  he  should  insist  upon  being 
informed  of  all  the  facts.  He  can  then  form  an  opinion  as  to 
the  amount  that  should  be  set  up  as  an  accrued  liability,  or,  if 
the  outcome  is  uncertain,  as  a  reserve  against  possible  loss." 


LEGAL  PHASES 

(Note.  In  connection  with  the  discussion  of  contingent  liabilities  on 
account  of  accommodation  endorsements,  it  is  appropriate  to  quote  from 
the  negotiable  instruments  law  which  regulates  endorsements  of  negotiable 
instruments.) 

What  Constitutes  Negotiation.  An  instrument  is  ne- 
gotiated when  it  is  transferred  from  one  person  to  another  in 
such  manner  as  to  constitute  the  transferee  the  holder  thereof. 
If  payable  to  bearer  it  is  negotiated  by  delivery;  if  payable  to 
order  it  is  negotiated  by  the  endorsement  of  the  holder  and 
completed  by  delivery. 


NEGOTIABLE  INSTRUMENTS  173 

Endorsement;  How  Made.  "The  endorsement  must  be 
written  on  the  instrument  itself  or  upon  a  paper  attached  thereto. 
The  signature  of  the  endorser,  without  additional  words,  is 
sufficient  endorsement. 

Kinds  of  Endorsement.  "An  endorsement  may  be 
either  special  or  in  blank,  and  it  may  also  be  either  restrictive 
or  qualified,  or  conditional. 

Special  Endorsement.  "A  special  endorsement  specifies 
the  person  to  whom,  or  to  whose  order  the  instrument  is  to  be 
payable;  and  the  endorsement  of  such  endorsee  is  necessary 
to  the  further  negotiation  of  the  instrument. 

Blank  Endorsement.  "An  endorsement  in  blank  specifies 
no  endorsee,  and  an  instrument  so  endorsed  is  payable  to  bearer 
and  may  be  negotiated  by  delivery. 

Restrictive  Endorsement.  "An  endorsement  is  restric- 
tive, which  either: 

1.  Prohibits  the  further  negotiation  of  the  instrument;  or 

2.  Constitutes  the  endorsee  the  agent  of  the  endorser;  or 

3.  Vests  the  title  in  the  endorsee  in  trust  for  or  to  the 
use  of  some  other  person. 

But  the  mere  absence  of  words  implying  power  to  negotiate 
does  not  make  an  endorsement  restrictive. 

Qualified  Endorsement.  "A  qualified  endorsement  con- 
stitutes the  endorser  a  mere  assignor  of  the  title  to  the  instru- 
ment. It  may  be  made  by  adding  to  the  endorser's  signature 
the  words  'without  recourse'  or  any  words  of  similar  import. 
Such  an  endorsement  does  not  impair  the  negotiable  character 
of  the  instrument. 

Conditional  Endorsement.  "Where  an  indorsement  is 
conditional,  a  party  required  to  pay  the  instrument  may  disregard 
the  condition  and  make  payment  to  the  endorsee  or  his  trans- 
feree, whether  the  condition  has  been  fulfilled  or  not.  But 
any  person  to  whom  an  instrument  so  endorsed  is  negotiated 
will  hold  the  same,  or  the  proceeds  thereof,  subject  to  the  rights 
of  the  person  endorsing  conditionally. 

Striking  out  Endorsement.  "The  holder  may  at  any 
time  strike  out  any  endorsement  which  is  not  necessary  to  his 
title.  The  endorser  whose  endorsement  is  struck  out,  and  all 
endorsers  sudsequent  to  him,  are  thereby  relieved  from  liability 
on  the  instrument." 


174  PUBLIC  ACCOUNTING  AND  AUDITING 

A.    THEORY  QUESTIONS 

1.  What  steps  should  an  auditor  take  to  insure,  so  far  as 
possible,  that  accounts  presented  to  him  for  audit  contain  all 
the  liabilities  of  the  company?  Inst.  Ex.   1917. 

2.  Outline  the  work  which  should  be  done  in  connection 
with  notes  and  bills  payable  in  an  audit  for  credit  purposes  of 
a  merchandising  company.  Inst.  Ex.  1918. 

3.  How  would  you  ascertain  whether  a  Balance  Sheet  con- 
tains all  the  liabilities  for  purchases  of  supplies  and  raw  material  ? 

C.  P.  A.  Ind. 

4.  What  are  contingent  liabilities?     Should  they  be  em- 
braced in  a  Balance  Sheet?     Give  an  example.     C.  P.  A.  Ind. 

5.  State  three  kinds  of  contingent  liabilities.    How  should 
they  be  shown  on  the  Balance  Sheet?  C.  P.  A.  Mass. 

6.  (a)  What  different   methods   should   be   employed   in 
books  of  account  for  keeping  track  of  notes  endorsed  for  ac- 
commodation and  notes  endorsed  in  the  regular  order  of  busi- 
ness? 

(b)  How  would  you  indicate  in  books  of  account  the 
contingent  liability  arising  in  each  case?  C.  P.  A.  Mich. 

7.  Describe  the  voucher  system  and  state  some  of  the 
advantages  and  disadvantages  of  the  system.       Inst.  Ex.  1918. 

8.  You  find  that  a  group  of  accounts  receivable  have  been 
assigned  to  secure  a  loan.     Does  that  affect  the  value  of  any 
other  creditor's  claim  in  case  of  failure  before  the  loan  is  paid? 
Should  any  reference  to  the  fact  be  made  in  your  report?    How 
would  you  set  up  that  fact  in  the  Balance  Sheet? 

C.  P  .A.  Mich. 

B.    ACCOUNTING  PROBLEMS 
Balance  Sheet 

December  31,  1916 
ASSETS 

Cash $    3,000.00 

Accounts  receivable 15,700.00    $18,700.00 


Inventories: 

Finished  goods 154,500.00 

Goods  in  process 8,350.00 

Materials 55,000.00     217,850.00 


236,550.00 

Land 40,000.00 

Buildings $94,000.00 

Less  reserve  for  depre- 
ciation     14,000.00       80,000.00 

(Concluded  on  next  page) 


ACCOUNTING  PROBLEMS  175 

Machinery  and  fixtures 81,000.00 

Less  reserve  for  depre- 
ciation    21,000.00       60,000.00     180,000.00 


Deferred  charges: 

Insurance  and  taxes 1,100.00 


Total  assets 417,650.00 

Deficit 52,850.00 


$470,500.00 


LIABILITIES 


Notes  payable. .  . $275,000.00 

Accounts  payable 15,500.00  $290,500.00 


Capital  stock: 

Preferred 100,000.00 

Common 80,000.00     180,000.00 


$470,500.00 

The  foregoing  was  the  Balance  Sheet  of  a  corporation, 
December  31,  1916,  incorporated  January  I,  1910,  and  during 
the  ensuing  year  the  following  transactions  occurred : 

Sales,  net $550,000.00 

Purchases,  net — raw  material 347,000.00 

Raw  material  inventory  increased 64,000.00 

Labor 60,000.00 

Total  manufacturing  expense 35,900.00 

Process  inventory  increased 20,000.00 

Finished  goods  inventory  decreased 36,000.00 

Total  selling  expense 35,000.00 

Total  administrative  expense 26,000.00 

Notes  payable  have  been'  renewed  as  they  became  due, 
except  that  $100,000.00,  held  by  the  largest  owners  in 
the  company,  has  been  donated  to  the  company,  July 

I,  1917 $100,000.00 

$5,000.00  of  3^%   Liberty   Bonds   have 

been  bought 5,000.00 

$2,000.00  has  been  donated   to   the   Red 

Cross 2,000.00 

Notes : 

Depreciation   on    buildings,    estimated    life   47   years, 
beginning  January  I,  1910. 

Depreciation  on  machinery,  estimated  life  27  years, 
beginning  January  I,  1910. 


176  PUBLIC  ACCOUNTING  AND  AUDITING 

Accounts   receivable   were   $45,000.00,    and   accounts 
payable  $15,000.00  at  the  close  of  the  year. 
There  was  accrued  interest  payable  $2,500.00,  Decem- 
ber 31,  1917. 

Prepare  Trial  Balance  and  Balance  Sheet  as  on  Dec.  31 , 1917. 

Inst.  Ex.  1918. 

(Note.  It  will  be  necessary  to  set  up  skeleton  ledger  accounts  to  obtain 
a  Trial  Balance.  No  information  is  given  as  to  the  amount  of  interest  paid 
during  the  year.  The  date  and  method  of  acquiring  the  Liberty  Bonds  is  not 
shown.  Since  this  information  is  not  given  in  the  problem,  you  may  ignore 
the  element  of  interest.  You  may  assume  that  the  same  amount  of  insur- 
ance and  taxes  is  to  be  deferred  as  at  the  end  of  the  previous  year.) 


C.    LEGAL  QUESTIONS 

1.  How  are  negotiable  instruments  negotiated? 

C.  P.  A.  Mich. 

2.  A  note  non-negotiable  in  form  is  executed  and  delivered 
by  A  to  B  and  endorsed  by  B  to  C.    A  refuses  to  pay  it  when 
due,  claiming  want  of  consideration.     C  brings  suit  against  A 
averring  that  he  was  a  holder  in  due  course.    Can  A  successfully 
defend  the  action  if  want  of  consideration  is  established?     Give 
reasons.  Inst.  Ex.  1918. 

3.  A  negotiable  note  executed  and  delivered  by  A  to  B 
passes  in  due  course  to  and  is  endorsed  in  blank  by  B,  C,  D  and  E; 
F  is  the  last  holder  and  strikes  out  C's  endorsement.     What 
is  the  liability  of  C,  D  and  E  on  their  endorsement? 

Inst.  Ex.  1918. 

4.  As  an  accommodation  to  B,  A  on  June  I,  1918,  endorsed 
B's  note  for  $1,000  payable  to  C's  order  on  July  I,  1919.     On 
July  2,  1919,  C  endorsed  and  delivered  the  note  to  D.     What 
rights,  if  any,  has  D  against  A?  Inst.  Ex.  1919. 

5.  New   York,    April    10,    1916. 
Thirty  days  after  date  I  promise  to  pay  to  the  order 

of  C.  D.  One  Hundred  Dollars. 

(Signed)     A.  B. 
Endorsed  in  blank  "without  recourse."         C.  D. 

What  does  the  endorser  warrant  by  his  endorsement? 

Inst.  Ex.  1917. 


Chapter  Twelve 


FIXED  LIABILITIES 

"Any  debt  the  maturity  of  which  extends  beyond  the 
period  adopted  within  that  business  for  current  liabilities  will 
usually  be  grouped  with  the  fixed  liabilities,  there  seldom  being 
an  intermediate  group." — Kester. 

In  Chapter  Two,  page  27,  we  quoted  from  the  Public  Service 
Commission  of  New  York  on  what  comprised  "Funded  Debt." 
Long-term  obligations,  usually  in  the  form  of  mortgaged  or 
bonded  indebtedness,  are  called  fixed  liabilities — sometimes 
known  as  LOAN  CAPITAL  as  distinguished  from  SHARE 
CAPITAL. 

Loan  capital  usually  has  as  security  some  specific  form  of 
property,  such  as  land,  buildings,  equipment,  etc.,  which  have 
been  classified  and  included  among  the  fixed  assets  of  the  con- 
cern. Under  these  circumstances  the  general  creditors  can 
only  claim  the  equity  or  difference  between  the  realizable  value 
of  the  specific  portion  of  the  assets,  and  the  amount  of  the  loan 
which  has  been  secured  by  it. 

When  it  becomes  necessary  or  advisable  to  raise  additional 
capital  and  it  is  not  desired  to  increase  the  share  capital,  long 
time  notes  or  bonds,  usually  secured  by  mortgages,  are  issued. 
In  the  case  of  an  individual  or  a  partnership,  it  is  quite  cus- 
tomary to  issue  notes  secured  by  first  or  second  mortgages  on 
the  fixed  assets  or  real  property  owned,  but  in  the  case  of  a 
corporation  it  is  more  common  to  issue  bonds. 

MORTGAGES 

Definition.  A  mortgage  is  a  conditional  title  to  property 
given  by  the  owner  to  another  to  secure  the  payment  of  a  debt 
or  the  discharge  of  some  obligation.  It  is  similar  to  a  deed 
and  conveys  title  to  the  property  on  which  the  mortgage  is 
placed,  but  upon  some  condition.  That  condition  is  the  failure 
to  make  prompt  payment  of  an  obligation  or  debt  at  maturity. 
The  tendency  is  to  regard  a  mortgage  as  a  lien  on  the  property 
and  not  as  an  actual  conveyance.  The  mortgagor  retains  physi- 
cal possession  of  the  property  and  is  entitled  to  the  income  there- 
from and  may  use  the  property  just  as  though  it  were  his  own. 
Of  course,  he  must  not  impair  its  value  and  he  must  comply 
with  all  the  conditions  in  the  mortgage  contract.  The  holder  of 
a  mortgage  (the  mortgagee)  has  practically  no  control  over  the 
property  or  over  the  operation  of  the  concern  involved. 

177 


178  PUBLIC  ACCOUNTING  AND  AUDITING 

Real  or  Personal  Property  May  Be  Mortgaged.     "In 

equity,  whatever  property,  real  or  personal,  is  capable  of  an 
absolute  sale,  may  be  the  subject  of  a  mortgage."* 

Mortgages  on  chattel  property  are  usually  for  a  short  period 
of  time  and  are  classed  as  current  liabilities,  but  mortgages 
on  real  property  as  security  for  notes  or  bonds,  due  at  some  time 
in  the  future  beyond  that  for  which  liabilities  are  classed  as 
current,  would  be  considered  fixed  liabilities. 

Kinds  of  Mortgages.  Mortgages  are  known  as  either 
chattel  or  real  estate  mortgages,  depending  on  the  property 
which  is  the  basis  of  the  security.  They  are  sometimes  known 
as  purchase  money  or  building  and  loan  mortgages,  depending 
on  the  purpose  of  the  mortgage.  They  may  also  be  classified 
as  to  precedence  as  first  mortgages,  second  mortgages,  etc.  A 
first  mortgage  takes  precedence  over  a  second  mortgage  and  so 
on.  In  case  of  liquidation  of  capital  assets,  holders  of  mort- 
gages stand  in  order  according  to  the  class  of  mortgage  held. 

Chattel  Mortgages.  The  only  difference  between  a 
chattel  mortgage  and  a  real  estate  mortgage  is  in  the  kind  of 
property  conveyed  as  security.  Chattel  mortgages  are  placed 
on  chattel  or  personal  property.  Real  estate  mortgages  are 
placed  on  real  property. 

Purchase  Money  Mortgages.  These  are  mortgages 
given  for  part  or  the  whole  of  the  purchase  price  of  land.  They 
take  precedence  over  all*  claims  of  the  general  creditors.  The 
mortgage  may  be  given  either  to  the  person  from  whom  the  land 
is  purchased  or  to  a  third  person. 

Building  and  Loan  Mortgages.  These  are  frequently 
given  to  secure  funds  for  erecting  a  building.  The  money  is 
paid  over  as  the  building  is  constructed  and  reaches  certain 
stages  mentioned  in  the  mortgage  contract,  or  the  entire  amount 
may  be  delivered  to  a  trust  company  to  be  held  in  trust  and  paid 
over  as  the  installments  fall  due.  If  the  money  is  held  by  the 
mortgagee  and  paid  in  installments,  interest  can  only  be  charged 
from  the  date  of  the  actual  payment  of  the  installments,  but  if 
placed  in  the  hands  of  a  trust  company  to  be  paid  in  install- 
ments, interest  may  be  charged  on  the  full  amount.  Of  course, 
the  trust  company  will  also  pay  a  low  rate  of  interest  on  the 
amount  deposited. 

Accounting  Procedure.  Mortgages  used  as  security 
for  notes  are  usually  classed  as  mortgages  payable  on  the  books 
of  account,  while  those  used  as  security  for  bonds  are  classed  as 
bonds  payable.  The  usual  procedure  with  mortgages  payable 
is  the  same  as  with  notes  payable.  The  Mortgages  Payable 
account  is  credited  with  each  mortgage  issued  and  debited  when 
the  mortgage  has  been  paid.  These  transactions  will  usually 
be  found  recorded  in  the  general  journal  and  cash  book.  They 
are  not  sufficiently  numerous  to  require  special  columns  and, 
therefore,  all  items  are  posted  individually. 

*\Vright  v.  Shumay,  30  Fed.  Cases,  No.  18,093;  l  Biss.  23-26. 


BONDS  179 

Unlike  bonds,  mortgages  are  seldom  sold  at  either  a  discount 
or  a  premium.  The  amount  received  is  usually  equal  to  the 
face  of  the  mortgage,  hence  mortgages  should  be  recorded,  like 
notes,  at  their  face  or  par  value.  In  other  words,  the  interest 
rate  on  mortgages  is  nearly  always  equal  to  the  effective  market 
rate  for  the  particular  type  of  equity  involved. 

BONDS 

Definition.  A  bond  is  simply  a  long-term  note — an 
interest  bearing,  negotiable  instrument,  under  seal,  promising 
to  pay  a  certain  sum  of  money  at  a  definite  or  determinable 
future  date.  It  is  usually  secured  by  a  pledge  of  certain  proper- 
ties, real  or  personal,  as  to  either  or  both  principal  and  interest. 

Bonds  vs.  Notes.  A  corporation  may  borrow  money 
the  same  as  an  individual.  If  only  a  small  amount  is  desired 
or  it  is  wanted  for  a  short  time  only,  notes  are  usually  given. 
These  notes  may  be  secured  or  unsecured.  If  unsecured, 
they  are  classed  as  current  liabilities  and  are  called  notes  pay- 
able on  the  books  of  account.  If  secured  by  a  mortgage,  they 
are  usually  called  mortgages  payable  on  the  books  of  account 
and  may  be  classed  as  either  current  or  fixed  liabilities,  de- 
pending on  the  length  of  time  to  maturity. 

When  the  amount  to  be  borrowed  is  large  and  is  wanted  for 
a  long  period  of  time,  say  from  five  to  fifty  years,  then  bonds 
instead  of  notes  are  given.  There  is  said  to  be  a  bond  issue. 
This  consists  of  a  number  of  bonds,  which  may  vary  in  de- 
nomination, but  which  are  all  of  like  general  tenor,  and  if  secured 
#re  all  secured  alike  under  one  "deed  of  trust". 

Deed  of  Trust.  This  is  a  mortgage  on  certain  specified 
property  placed  in  the  hands  of  a  trustee  who  represents  the 
bondholders.  The  deed  of  trust  states  at  length  the  terms  and 
conditions  under  which  the  bonds  are  issued  and  under  which 
the  property  for  their  security  is  held.  In  the  bonds,  reference 
is  made  to  the  deed  of  trust  by  which  they  are  secured.  It  will 
be  seen,  therefore,  that  both  the  deed  of  trust  and  the  bonds 
issued  refer  to  each  other  in  such  a  manner  that  all  terms  and 
conditions  are  clearly  stated  in  both  instruments.  The  trustee 
has  the  right  to  act  in  behalf  of  the  bondholders  and  may  bring 
foreclosure  proceedings  if  it  becomes  necessary  to  do  so.  If 
the  trustee  fails  to  do  so,  any  bondholder  may  bring  foreclosure 
proceedings  for  the  benefit  of  all  the  bondholders.  Of  course, 
he  must  show  the  court  that  this  action  is  necessary  to  safe- 
guard the  interest  of  the  bondholders  and  that  the  trustee 
refuses  to  act. 

Security.  Formerly  bonds  were  commonly  supposed 
to  be  secured  by  real  estate  mortgages,  except  when  otherwise 
specifically  designated.  In  these  times,  bonds  may  or  may  not 
be  secured  at  all.  Often  they  are  nothing  more  than  promissory 
notes;  in  fact,  are  not  so  valuable  because  they  do  not  mature 
for  a  longer  time.  It  will  be  readily  seen,  therefore,  that  an 


I8o  PUBLIC  ACCOUNTING  AND  AUDITING 

auditor  must  be  able  to  determine  the  value  of  the  security  in 
order  to  place  a  valuation  on  the  bonds. 

There  are  so  many  different  kinds  of  bonds  that  we  can 
only  describe  a  few  of  each  kind  here.  They  may  be  subdivided 
as  to  security,  as  to  purpose,  as  to  payment  of  interest,  and  as 
to  payment  of  principal. 

AS  TO  SECURITY 

Debenture  Bonds.  We  have  already  stated  that  bonds 
may  be  secured  or  unsecured.  Unsecured  bonds  are  usually 
termed  "Debentures"  or  "Debenture  Bonds."  This  term  is  also 
often  used  to  describe  bonds  partially  secured,  those  secured  by 
collateral  and  those  on  which  the  payment  of  the  interest  is 
contingent  upon  the  earnings  of  the  company.  This  interest 
may  be  cumulative  or  non-cumulative. 

An  unsecured  debenture  bond  is  a  mere  promise  to  pay 
and  is  inferior  to  any  secured  liabilities  of  the  company.  It  is, 
however,  superior  to  preferred  stock  in  that  the  liability  on 
account  of  interest  payable  ranks  ahead  of  the  dividends  on 
the  preferred  stock.  The  value  of  unsecured  bonds  depends 
entirely  on  the  financial  strength  of  the  issuing  company.  No 
foreclosure  proceedings  can  be  instituted  because  no  mortgage 
has  been  given.  Bonds  secured  by  depositing  stocks  and 
bonds  of  another  company  (owned  by  the  issuing  company) 
in  the  hands  of  a  trustee,  are  frequently  known  as  "collateral 
trust  bonds"  and  may  be  classed  as  debentures  as  stated  above. 

Example:  Lake  Shore  &  Michigan  Southern  2.s-year  debenture  43,  due 
September  i,  1928,  were  originally  debentures,  but  are  now  secured  by  direct 
second  lien  on  the  Lake  Shore  property  of  New  York  Central  System. 

Mortgage  Bonds.  Mortgage  bonds,  as  the  name  implies, 
are  those  secured  by  a  mortgage,  or  deed  of  trust  on  part  or  all 
of  the  property  of  the  issuing  company.  These  bonds  may 
be  known  as  first,  second,  third,  etc.  mortgage  bonds  accord- 
ing to  the  rank  of  the  mortgage  or  deed  of  trust  by  which  they 
are  secured.  A  first  mortgage  bond  is  a  first  lien  on  the  property 
mortgaged  except  in  cases  where  a  builder's  lien,  receiver's 
certificate  or  some  similar  obligation  takes  precedence.  A 
second  mortgage  bond  is  one  in  which  the  security  is  a  second 
mortgage  on  the  same  property. 

Example:  American  Smelting  &  Refining  First  Mortgage  53,  due 
April  I,  1947,  secured  by  first  mortgage  on  entire  property  of  company  and  by 
pledge  of  capital  stock  of  five  subsidiaries. 

Income  Bonds.  These  have  already  been  defined  as 
bonds  on  which  the  payment  of  interest  is  contingent  upon  the 
earnings  of  the  issuing  company.  Such  bonds  are  a  lien  on  the 
net  income  of  the  company.  If  there  are  no  net  profits,  the 
interest  is  not  a  liability  unless  it  is  cumulative.  The  principal 
of  such  bonds  may  be  secured  or  unsecured.  If  unsecured  they 
are  frequently  called  debenture  bonds. 


BONDS  181 

Guaranteed  Bonds.  These  are  bonds  the  payment  of 
which,  either  as  to  principal  or  interest,  or  both,  is  guaranteed 
by  another  company.  This  guarantee  to  be  binding  must  be 
in  writing  and  must  be  written  on  the  bond  itself,  or  be  attached 
to  it.  Such  bonds  are  frequently  issued.  For  instance,  a  sub- 
sidiary company  may  issue  bonds  guaranteed  by  the  parent 
or  holding  company  of  which  it  forms  a  part. 

AS  TO  PURPOSE 

Improvement  Bonds  are  bonds  issued  for  the  purpose  of 
property  improvements.  They  may  be  either  debenture  or 
mortgage  bonds  and  may  be  secured  or  unsecured  as  to  principal 
or  interest,  or  both. 

Example:  Miami  Conservancy  District,  Ohio,  5V£%  bonds,  issued  De- 
cember I,  1917,  "for  the  prevention  of  floods  and  protection  of  certain  cities, 
including  Dayton,  Hamilton,  Middletown,  Piqua,  Troy  and  other  smaller 
municipalities." 

Refunding  Bonds  are  bonds  issued  to  raise  funds  to 
replace  or  redeem  other  bonds  which  are  maturing.  In  some 
instances  they  are  exchanged  directly  for  the  old  bonds,  but  more 
often  sold  and  the  money  used  to  retire  the  maturing  bonds. 
The  interest  rate  on  these  bonds  may  be  higher  or  lower  than 
on  those  bonds  being  retired,  depending  on  money  conditions 
at  the  time  of  issue. 

Example:  Illinois  Central  Refunding  Mortgage  43,  due  November  i, 
J955-  Secured  by  a  direct  mortgage  on  21,172  miles  of  road,  etc. 

Adjustment  Bonds  are  bonds  issued  for  the  purpose  of 
readjusting  or  consolidating  existing  indebtedness.  They  are 
very  similar  to  refunding  bonds. 

Purchase  Money  Bonds  are  bonds  given  to  secure  funds 
with  which  to  purchase  the  property  by  which  they  are  secured. 
(See  Purchase  Money  Mortgages,  Page  178.) 


Registered  Bonds  are  registered  on  the  books  of  the  issuing 
company  in  the  name  of  some  particular  individual  or  company 
in  much  the  same  manner  as  capital  stock.  The  interest  and 
principal  are  then  payable  only  to  the  registered  holder  of  the 
bonds.  Such  bonds  may  be  transferred  by  assignment.  When 
assignment  is  made  the  assignee  surrenders  the  old  bond  and  is 
given  in  exchange  a  bond  issued  in  his  own  name.  The  trans- 
fer is  made  on  the  books  of  the  issuing  company. 

Coupon  Bonds  are  bonds  usually  made  payable  to  bearer 
and  to  which  are  attached  interest  coupons.  These  interest 
coupons  are  always  made  payable  to  bearer.  They  are  clipped 
off  at  maturity  and  presented  for  payment.  There  will  be  as 
many  coupons  attached  as  there  are  interest  due  dates.  United 
States  Government  Liberty  and  Victory  Bonds  are  issued  in 


182  PUBLIC  ACCOUNTING  AND  AUDITING 

both  registered  and  coupon  forms.  The  advantages  of  the 
coupon  bonds  is  the  ease  with  which  they  may  be  transferred. 
They  are  transferrable  by  delivery  alone,  while  the  registered 
bonds  are  transferrable  by  assignment  only.  A  disadvantage 
of  coupon  bonds  is  that  if  lost  or  stolen,  the  finder  or  holder 
may  dispose  of  them  easily  and  once  in  the  hands  of  an  innocent 
holder  they  become  valid.  If  a  registered  bond  is  lost  or  stolen, 
it  is  practically  impossible  to  realize  on  it  because  it  is  payable 
only  to  the  party  named  in  the  bond  and  could  only  be  trans- 
ferred by  assignment  which  would  require  forgery.  This 
forging  would,  therefore,  prevent  a  valid  transfer.  Both  coupon 
and  registered  bonds  are  often  issued  under  the  same  security 
or  deed  of  trust.  Coupon  bonds  are  often  subject  to  being 
registered  if  desired.  A  bond  may  be  registered  as  to  principal 
only  and  the  interest  may  be  payable  in  the  form  of  coupons. 
In  this  event  interest  is  payable  to  whoever  holds  the  coupons, 
but  the  principal  is  payable  only  to  the  party  registered  and 
named  in  the  bond. 

Participating  Bonds  are  bonds  in  which  it  is  specified 
that  the  holder  is  to  share  in  the  profits  of  the  issuing  company. 
A  certain  rate  of  interest  may  or  may  not  be  specified  and  the 
holder  may  share  in  the  net  income  the  same  as  actual  stock- 
holders. These  are  sometimes  known  as  income  bonds.  (See 
page  1 80.) 

AS  TO  PAYMENT  OF  PRINCIPAL 

Gold  Bonds  are  bonds  which  expressly  provide  for  payment 
in  gold.  Such  provisions  are  legal  and  enforceable.  If  no 
medium  of  payment  is  specified,  legal  tender  is  assumed. 

Convertible  Bonds  are  bonds  which  carry  the  right  of 
conversion  into  other  securities  of  the  same  company.  Usually 
convertible  bonds  may  be  exchanged  for  common  or  preferred 
stock  within  a  certain  time  and  at  a  fixed  rate  of  exchange. 
Example:  American  Telephone  and  Telegraph,  7-year  convertible 
6s,  due  August  I,  1925,  convertible  at  par  into  common  etock  of  the  com- 
pany at  $106.00  per  share  after  August  i,  1920. 

Serial  Bonds  are  bonds  issued  in  series,  one  series  payable 
each  year  until  the  entire  issue  has  been  redeemed  or  retired. 
It  will  be  seen,  therefore,  that  the  security  back  of  these  bonds 
increases  in  proportionate  value  as  each  series  of  the  bonds  is 
redeemed.  In  some  instances  the  terms  of  the  issue  provide 
for  relinquishing  a  part  of  the  security  after  certain  redemption 
stages  are  reached. 

Callable  or  Redeemable  Bonds  are  bonds  that  may  be 
redeemed  by  the  issuing  company  before  the  maturity  date 
fixed  by  the  deed  of  trust.  Often  a  sinking  fund  is  established 
and  the  bonds  are  redeemed  or  called  in  and  then  cancelled. 
Sometimes  the  issuing  company,  instead  of  establishing  a  sink- 
ing fund,  simply  calls  in  a  part  of  the  bonds  periodically  and 
cancels  them.  Many  bond  issues  contain  provision  to  the 


BONDS  183 

effect  that  upon  any  interest  date  (previous  notification  having 
been  given)  they  may  be  redeemed,  all  or  in  part,  at  a  stated 
price  plus  accrued  interest. 

Example :      Chesapeake  &  Ohio,  2oyear  convertible  4  J^s,  due  February  I , 
1930.     Callable  for  redemption  after  February  I,  1920. 

Procedure  in  Issuing  Bonds.  The  following  is  a  brief 
outline  in  general  of  the  various  steps  to  be  taken  in  a  bond 
issue.  Of  course,  a  great  deal  will  always  depend  upon  the 
kind  of  bonds  being  issued,  the  purpose  of  the  issue  and  the  con- 
ditions of  the  issue.  (It  is  understood  that  this  outline  is  sub- 
ject to  statutory  regulations  in  the  various  states  and  that  a 
bond  issue  should  always  be  made  under  the  direction  and  super- 
vision of  competent  attorneys  familiar  with  the  statutes.) 

(1)  Meeting  of  Directors.     A  preliminary  meeting  of 
the  Board  of  Directors  is  held  and  a  resolution  passed  recom- 
mending a  bond  issue.     A  special  meeting  of  the  stockholders 
is  then  called.     The  stockholders  usually  have  the  authority 
to  authorize  the  bond  issue,  but  even  where  the  directors  have 
that  authority  it  is  common  and  good  practice  to  get  the  en- 
dorsement of  the  stockholders. 

(2)  Meeting  of  Stockholders.     At  this  meeting  a  state- 
ment of  the  proposed  issue  is  submitted  for  consideration.     This 
statement  stipulates  all  the  conditions  of  the  issue,  the  time  the 
bonds  are  to  run,  the  security,  terms  of  payment,  rate  of  interest, 
redemption  conditions,  etc.     After  due  consideration  a  resolu- 
tion is  passed.     Often  this  resolution  is  voted  upon  by  submitting 
it  to  the  individual  stockholders  after  this  meeting.     In  other 
words,  the  vote  is  obtained  by  mail. 

(3)  Bond  Issue  Authorized.     After  the  bond  issue  is 
approved  by  the  stockholders,  the  directors  hold  another  meet- 
ing and  pass  a  formal  resolution  authorizing  the  bond  issue  in 
due  form  by  the  officers  of  the  corporation. 

(4)  Proposed    Issue    Submitted    to    Public    Service 
Commission.     In  states  where  a  Public  Service  Commission 
exists,  bond  issues  of  all  corporations  coming  under  its  direction 
must  have  its  approval  before  issuance. 

(5)  The  Deed  of  Trust.     A  trustee  is  selected.     This  is 
usually  a  trust  company.     The  proper  officers  of  the  issuing 
company  draw  and  duly  execute  a  deed  of  trust,  conveying 
certain  properties  to  the  trustee,  and  setting  forth  all  the  con- 
ditions under  which  the  bonds  are  issued.     If  real  estate  is  con- 
veyed, a  copy  of  the  deed  of  trust  must  be  filed  in  every  county 
where  the  real  estate  is  located. 

(6)  Preparation    of    Bonds.     The    bonds    are    usually 
engrossed  and  coupons  are  attached,  if  the  issue  is  of  coupon 
bonds.     The  trustee's  certificate  appears  on  the  bonds.      The 
form  of  certificate  appearing  on  the  back  of  the  bonds  of  the 
United  States  Steel  Corporation  reads  as  follows: 


184  PUBLIC  ACCOUNTING  AND  AUDITING 

"THIS  IS  TO  CERTIFY  that  this  bond  is 
one  of  the  issue  of  bonds  of  United 
States  Steel  Corporation  mentioned  in 
the  indenture  dated  April  1,  1903,  with- 
in referred  to,  executed  by  United 
States  Steel  Corporation  to  the  under- 
signed as  Trustee. 

United  States  Trust  Company  of 
New  York. 

By " 

(7)  Sale  of  Bonds.     The  bonds  may  be  sold  direct  to 
the  public  or  may  be  sold  through  some  firm  of  bankers.     Pro- 
vision for  selling  the  bonds  is  usually  arranged  for  before  the  bond 
issue  is  authorized  or  soon  thereafter. 

(8)  Provision  for  Paying  Interest  and  for  Redeeming 
the    Principal.  Some  definite  provision  must  be  made  for  the 
payment  of  the  interest  and  for  the  redemption  of  the  bonds  at 
maturity.     This  latter  is  usually  provided  for  in  the  deed  of 
trust,  but  a  method  of  establishing  a  fund  from  which  to  meet 
these  obligations  must  be  arrived  at. 

1.    ACCOUNTING  THEORY 

Bond  Account.  The  object  of  this  account  is  to  show 
the  amount  of  bonds  authorized  by  the  deed  of  trust.  The 
account  is  charged  for  the  par  value  of  the  bonds  redeemed 
and  cancelled,  and  is  credited  for  the  par  value  of  the  bonds 
authorized  by  the  deed  of  trust.  It  will  be  seen  that  the  differ- 
ence between  the  two  sides  of  the  account  represents  the  par 
value  of  bonds  authorized  and  not  yet  cancelled. 

Unissued  Bond  Account.  The  object  of  this  account 
is  to  show  the  par  value  of  the  unissued  bonds,  that  is,  those 
bonds  authorized  but  not  yet  sold.  The  account  is  charged 
for  the  par  value  of  the  bonds  authorized  and  is  credited  for 
the  par  value  of  bonds  sold  and  issued.  The  balance  of  this 
account  deducted  from  the  balance  of  the  Bond  account  will 
show  the  par  value  of  bonds  outstanding 

Bond  Subscription  Account.  The  object  of  this  account 
is  to  show  the  total  subscriptions  for  bonds  on  the  installment 
plan.  Usually  the  bonds  are  not  issued  until  all  installments 
have  been  paid  in  full;  therefore,  this  account  is  credited  for  the 
par  value  of  bonds  subscribed  for  and  is  charged  for  the  par 
value  of  subscribed  bonds  when  issued.  The  balance  of  the 
account  represents  the  par  value  of  bonds  subscribed  for  but 
not  yet  issued. 


BONDS  185 

Bond  Premium  Account.  The  object  of  this  account 
is  to  show  the  amount  in  excess  of  the  par  value  realized  through 
the  sale  of  the  bonds.  When  the  bonds  are  sold  above  par  the 
excess  is  credited  to  this  account.  The  account  should  be 
written  off  during  the  life  of  the  bonds. 

Bond  Discount  and  Expense  Account.  The  object 
of  this  account  is  to  show  the  cost  of  the  issue.  All  expenses* 
incident  to  the  bond  issue  and  the  difference  between  the  amount 
realized  and  the  par  value  of  the  bonds,  when  sold  below  par, 
are  charged  to  this  account. 

If  desired,  separate  accounts  may  be  kept  with  "Bond 
Discount"  and  "Bond  Expense."  Bond  discount  is  considered 
an  addition  to  the  amount  of  interest  paid  but  should  be  pro- 
rated over  the  life  of  the  bonds. 

Bond  Interest  Account.  The  object  of  this  account 
is  to  show  the  interest  paid  on  bonds.  At  the  end  of  each  fiscal 
period,  or  oftener,  this  account  is  closed  into  the  Profit  and  Loss 
account. 

Relation  of  Bond  Premium  or  Discount  to  Interest. 

The  premium  received  or  the  discounts  allowed  upon  the  sale 
of  bonds  is  said  to  represent  a  deduction  from,  or  an  addition  to, 
the  interest  paid  on  the  bonds. t  If  the  bonds  sell  at.  a  discount, 
the  borrower  pays  not  only  the  interest  but  also  the  discount 
for  the  use  of  the  money.  If  the  bond  sells  at  a  premium,  the 
principal  borrowed  is  more  than  par;  and  since  the  borrower 
does  not  have  to  pay  back  the  premium  at  maturity,  the  premium 
is  really  a  deduction  from  the  interest. 

It  will  be  seen,  therefore,  that  the  premium  or  discount 
should  be  written  off  over  the  life  of  the  bonds  by  either  credit- 
ing or  charging  a  proportionate  part  to  the  Interest  account 
and  through  this  to  Profit  and  Loss  at  the  end  of  each  fiscal 
period.  The  customary  method  is  to  credit  the  premiums  or 
debit  the  discounts  to  Profit  and  Loss,  periodically,  during  the 
life  of  the  bonds.  This  is  known  as  the  Straight  Line  Method. 


*"A11  expenses  connected  with  the  issue  and  sale  of  evidences  of  debt, 
such  as  fees  for  drafting  mortgages  and  trust  deeds,  fees  and  taxes  for  record- 
ing mortgages  and  trust  deeds,  cost  of  engraving  and  printing  bonds,  fees  paid 
trustees  provided  for  in  the  mortgages  and  trust  deeds,  fees  and  commissions 
paid  underwriters  and  brokers  for  marketing  such  evidences  of  debt,  and  other 
regular  expenses."  — Public  Service  Commission,  New  York. 

t"Premium  or  discount  on  bonds  is  a  deduction  from,  or  addition  to,  the 
nominal  rate  of  interest  which  the  bond  carries;  that  is  to  say,  there  is  a  rate 
known  as  the  true  or  effective  rate,  at  which  any  corporation  can  place  its 
bonds  at  par;  if  it  elects  to  place  them  at  any  other  rate,  the  bonds  will  sell 
at  a  premium  or  discount  as  the  case  may  be;  but  the  effective  rate  remains 
the  same  and  this  effective  rate  is  the  proper  charge  to  Income  account. 
Hence,  the  premium  or  discount  should  theoretically  be  spread  over  the  term 
of  the  bonds,  and  the  annual  installment  thereof  credited  or  charged  to  the 
Income  account  each  year." 

— "Accounting  Practice  and  Procedure,"  by  A.  Lowes  Dickinson. 


i86  PUBLIC  ACCOUNTING  AND  AUDITING 

However,  this  is  considered  unsound  accounting  practice  because 
it  results  in  an  erroneous  statement  of  the  operating  costs. 
Proper  accounting  calls  for  a  reflection  of  the  actual  interest 
cost  spread  over  the  life  of  the  bonds,  and  this  can  be  accom- 
plished only  by  adjusting  the  Interest  account. 

Effective  Rate  Method.  This  is  considered  the  best 
method  of  writing  off  bond  premiums  or  discounts.  The  actual 
amount  of  interest  paid  is  charged  to  the  Bond  Interest  account. 
If  the  bonds  were  sold  at  a  discount,  the  difference  between  the 
nominal  rate  (the  amount  actually  paid)  and  the  effective  rate 
(the  prevailing  rate  of  interest)  is  also  charged  periodically  to 
Bond  Interest  and  credited  to  Bond  Discount  and  Expense.  If 
the  bonds  were  sold  at  a  premium,  the  difference  between  the 
effective  and  nominal  rates  is  periodically  charged  to  Bond 
Premium  and  credited  to  Bond  Interest.  It  will  be  seen  that  this 
method  scientifically  writes  off  the  Bond  Premium  or  Bond 
Discount  and  Expense  accounts  during  the  life  of  the  bonds. 

2.     INCOME  TAX  PROCEDURE 

Amortization  of  Bond  Premiums.  The  Treasury  De- 
partment holds  that  the  difference  between  the  amount  realized 
and  the  par  value  of  bonds  when  sold  at  a  premium,  represents 
taxable  income.  It  need  not  be  rated  as  income  for  the  year 
in  which  the  bonds  are  sold,  but  may  be  prorated  over  the  life 
of  the  bonds. 

(Reg.  No.  45,  1919,  Art.  544,  ^[2.)  "If  bonds  are  issued 
by  a  corporation  at  a  premium,  the  net  amount  of  such  premium 
is  gain  or  income  which  should  be  prorated  or  amortized  over 
the  life  of  the  bonds.  If  thereafter  the  corporation  purchases 
and  retires  any  of  such  bonds  at  a  price  in  excess  of  the  issuing 
price  minus  any  amount  of  premium  already  returned  as  income, 
the  excess  of  the  purchase  price  over  the  issuing  price  minus 
any  amount  of  premium  already  returned  as  income  (or  over 
the  face  value  plus  any  amount  of  premium  not  yet  returned 
as  income)  is  a  deductible  expense  for  the  taxable  year.  If, 
however,  the  corporation  purchases  and  retires  any  of  such 
bonds  at  a  price  less  than  the  issuing  price  minus  any  amount 
of  premium  already  returned  as  income,  the  excess  of  the  issuing 
price  minus  any  amount  of  premium  already  returned  as  income 
(or  of  the  face  value  plus  any  amount  of  premium  not  yet  re- 
turned as  income)  over  the  purchase  price  is  gain  or  income  for 
the  taxable  year." 

Amortization  of  Bond  Discounts.  The  Treasury  De- 
partment holds  that  discounts,  commissions  for  selling,  and  other 
expenses  incidental  to  issuing  the  bonds,  represent  a  loss  and 
may  be  prorated  over  the  life  of  the  bonds. 


BONDS  187 

(Reg.  No.  45.  1919,  Art.  544,  ^[3.)  "If  bonds  are  issued 
by  a  corporation  at  a  discount,  the  net  amount  of  such  discount 
is  deductible  as  interest  and  should  be  prorated  or  amortized 
over  the  life  of  the  bonds.  If,  thereafter,  the  corporation  pur- 
chases and  retires  any  of  such  bonds  at  a  price  in  excess  of  the 
issuing  price  plus  any  amount  of  discount  already  deducted,  the 
excess  of  the  purchase  price  over  the  issuing  price  plus  any 
amount  of  discount  already  deducted  (or  over  the  face  value 
minus  any  amount  of  discount  not  yet  deducted)  is  a  deductible 
expense  of  the  taxable  year.  If,  however,  the  corporation  pur- 
chases and  retires  any  of  such  bonds  at  a  price  less  than  the 
issuing  price  plus  any  amount  of  discount  already  deducted, 
the  excess  of  the  issuing  price  plus  any  amount  of  discount 
already  deducted  (or  of  the  face  value  minus  any  amount  of 
discount  not  yet  deducted)  over  the  purchase  price  is  gain  or 
income  for  the  taxable  year." 

Procedure  When  Bonds  Issued  at  Par  Value  Are  Pur- 
chased for  Redemption.  (Reg.  No.  45,  1919,  Art.  544,  ^[i.) 
"If  bonds  are  issued  by  a  corporation  at  their  face  value,  the 
corporation  realizes  no  gain  or  Idss.  If  thereafter  the  corpora- 
tion purchases  and  retires  any  of  such  bonds  at  a  price  in  excess 
of  the  issuing  price  or  face  value,  the  excess  of  the  purchase 
price  over  the  issuing  price  or  face  value  is  a  deductible  expense 
for  the  taxable  year.  If,  however,  the  corporation  purchases 
and  retires  any  of  such  bonds  at  a  price  less  than  the  issuing 
price  or  face  value,  the  excess  of  the  issuing  price  or  face  value 
over  the  purchase  price  is  gain  or  income  for  the  taxable  year." 

Bond  Discount  Considered  Interest.  The  Treasury 
Department  holds  that  the  discount  on  bonds  sold  at  less  than 
par  is  to  be  treated  as  interest  paid  in  advance.  It  would, 
therefore,  seem  that  it  is  equally  good  practice  to  consider  the 
premium  on  bonds  sold  above  par  to  be  a  deduction  against 
the  amount  of  interest  paid. 

(Reg.  No.  45, 1919,  Art.  563.)  "If  it  sells  its  bonds  at  a  dis- 
count, the  amount  of  such  discount  is  treated  as  interest  paid, 
and  if  it  retires  its  bonds  at  a  price  in  excess  of  the  issuing  price, 
such  excess  may  usually  be  deducted  as  expense.  If  the  Cor- 
poration sells  its  capital  assets  for  less  than  their  cost  or  fair 
market  value  as  of  March  I,  1913,  the  loss  sustained  is  de- 
ductible." 

Interest  on  Liberty  Bonds  Exempt  from  Income  Tax. 

(Income-Tax   Primer,    1919,   Ques.    19.)     "To   what  extent  is 
interest  received  on  Liberty  bonds  exempt  from  income  tax? 

(a)  All  interest  received  upon  Liberty  bonds  is  exempt 
from  normal  tax. 

(b)  In  any  event,  interest  upon  the  3^  per  cent  Liberty 
bonds  of  the  first  series  is  exempt  from  both  normal  tax  and 
surtax. 


188  PUBLIC  ACCOUNTING  AND  AUDITING 

(c)  In  addition,  a  person  is  entitled  to  exemption  from 
tax   upon    interest   received   on   $5,000   aggregate   amount   of 
bonds  of  later  issues  and  war-savings  certificates. 

(d)  If  one  originally  subscribed  for  Liberty  bonds  of  the 
fourth  series  he  is  also  entitled  to  an  exemption  from  tax  on 
interest  received  upon  bonds  of  the  previous  issues  not  to  ex- 
ceed one  and  one-half  times  the  amount  of  the  fourth  Liberty 
bonds  originally  subscribed  for  and  still  owned,  not  to  exceed  in 
the  aggregate  $45,000. 

(e)  The  interest  received  on  not  exceeding  $30,000  principal 
amount  of  Liberty  bonds  into  which  first  Liberty  bonds  may  have 
been  converted  in  the  exercise  of  any  privilege  arising  as  a  con- 
sequence of  the  issue  of  the  fourth  Liberty  bonds  is  exempt. 

(f)  The  interest  received  on  not  exceeding  $30,000  prin- 
cipal amount  of  Liberty  bonds  of  the  fourth  issue  is  exempt. 

The  interest  upon  Liberty  bonds,  which  is  entirely  exempt 
from  income  tax  as  defined  above,  should  not  be  included  in 
the  gross  income  of  the  return,  but  should  be  reported  in  the 
return." 

3.    AUDITING  THEORY 

Quoting  from  the  Federal  Reserve  Bulletin : 

Listing  Mortgages  and  Bonds.  "A  copy  of  the  mort- 
gages must  be  examined  and  the  terms  thereof  noted.  The 
amount  of  bonds  registered,  issued,  and  in  treasury,  rate  of 
interest,  and  duration  of  the  bonds,  should  be  shown  on  the 
face  of  the  Balance  Sheet.  A  certificate  should  be  obtained 
from  the  trust  company  certifying  the  amount  of  bonds  out- 
standing, etc.,  as  verification  of  the  liability  stated  in  the  Balance 
Sheet.  The  interest  on  the  bonds  outstanding,  shown  in  the 
Balance  Sheet,  should  be  calculated  and  reconciled  with  the 
interest  on  bonds,  as  shown  in  the  Profit  and  Loss  account. 

Sinking  Funds.  "Sinking  fund  provisions  in  mortgages 
should  be  carefully  noted  and  care  should  be  taken  to  see  that 
they  are  provided  for  in  the  accounts  of  the  company,  and  any 
default  noted  in  the  Balance  Sheet. 

Redeemed  Bonds.  "Bonds  redeemed  during  the  period 
or  previously  should  be  examined  to  see  that  they  have  been 
properly  cancelled,  or,  if  they  have  been  destroyed,  a  cremation 
certificate  should  be  obtained  from  the  trustees. 

"Mortgages  sometimes  stipulate  that  the  current  assets 
must  be  maintained  at  a  certain  amount  in  excess  of  the  current 
liabilities,  and  the  auditor  must  give  due  consideration  to  such 
matters  and  any  other  stipulation  in  regard  to  the  accounts, 
or  any  audit  thereof,  that  may  be  referred  to  in  the  trust  deed, 
and  see  that  they  have  been  complied  with. 


BONDS  189 

Mortgages.  "As  a  mortgage  derives  its  chief  value  from 
the  fact  that  upon  registry  it  becomes  a  lien,  the  auditor  should 
verify  the  existence  of  such  an  obligation  by  inspecting  the 
public  records,  not  only  with  reference  to  such  as  may  be  found 
on  the  company's  books,  but  also  any  that  may  still  appear  on 
the  public  records  as  unsatisfied.  If  the  auditor  lacks  the 
necessary  facilities  for  making  a  search  it  will  be  worth  his  while 
to  arrange  with  a  local  lawyer  or  title  company  whereby,  for  a 
small  fee,  any  mortgages  or  judgments  entered  against  the  con- 
cern under  audit  will  be  reported  to  him. 

"In  any  event  the  auditor  must  verify  the  amount  as 
recorded  in  the  account,  the  rate,  the  due  date,  and  the  property 
covered  thereby. 

"It  should  be  borne  in  mind  that  a  payment  on  account  of 
a  mortgage  must  be  recorded  or  the  entire  amount  will  remain 
as  an  encumbrance  on  the  property.  Therefore,  if  payments 
on  account  appear,  the  auditor  should  ascertain  if  they  have  been 
so  recorded;  if  not,  the  fact  should  be  noted  on  the  Balance 
Sheet. 

Judgments.  "The  same  procedure  should  be  followed 
in  verifying  judgments  as  in  verifying  mortgages.  As  many 
business  men  consider  that  the  entry  of  an  invoice  is  an  ad- 
mission of  liability,  and  will  not  permit  the  entry  of  a  claim 
which  they  propose  to  fight,  it  is  sometimes  difficult  for  an 
auditor  to  find  any  evidence  of  such  liens.  Even  admitting 
the  fact,  they  may  still  refuse  to  allow  the  judgment  to  be 
entered  on  the  books  as  a  liability,  in  which  case  it  is  proper 
for  the  auditor  to  include  it  as  a  footnote  on  the  Balance  Sheet 
as  a  contingent  liability. 

Unpaid  Interest.  "When  considering  the  matter  of  liens 
it  should  be  noted  that  interest  unpaid  is  a  lien  as  well  as  unpaid 
principal,  so  where  the  auditor  finds  evidence  of  interest  on  liens 
being  in  default,  he  should  add  it  to  the  principal  in  each  case." 

4.     AUDITING  PROCEDURE 

Investigation  by  the  senior  shows  that  there  is  $100,000.00 
of  the  First  Mortgage  Bonds  of  the  Blank  Manufacturing  Com- 
pany outstanding.  These  are  5%,  2O-year  bonds.  Interest 
payable  semi-annually  on  January  15  and  July  15  of  each  year. 
As  shown  in  the  Trial  Balance,  December  31,  1918,  (see  page  50, 
Chapter  Four)  $2,500.00  had  been  deposited  for  bond  interest. 

The  policy  of  the  company  has  been  to  charge  off  5%  of 
bond  discount  annually,  thus  distributing  it  over  the  life  of  the 
bonds  on  a  straight  line  method  without  regard  to  the  rate  of 
interest  which  the  bonds  bear.  The  Bond  Discount  unamor- 
tized  now  stands  at  $6,000.00  and  the  Bond  Interest  account 
shows  a  debit  balance  of  $5,000.00,  this  amount  representing  the 
amount  of  interest  paid  on  January  15  and  July  15,  1917. 


190  PUBLIC  ACCOUNTING  AND  AUDITING 

A.     THEORY  QUESTIONS 

1.  Name   five  classes  of  bonds,   describing    briefly    each 
class  with  regard  to  issue,  purpose,  redemption,  etc. 

C.  P.  A.  Mich. 

2.  Do  unsold  bonds  of  a  railroad  company  constitute  a 
liability?     If  they  do,  under  what  account  would  they  appear 
in  the  ledger?  C.  P.  A.  Mich. 

3.  An    issue    of    Mortgage    Bonds    of    the    par   value    of 
$100,000.00  and  running  for  five  years  has  been  sold  at  90,  the 
money  to  be  used  in  the  erection  of  new  buildings.     How  should 
the  transaction  be  recorded  and  why?  C.  P.  A.  Mich. 

4.  If  a  bond  reads  at  4%,  but  the  amount  which  will  be 
received  is  1.05  of  the  nominal  par,  what  is  the  actual  percentage 
of  cost  income?  C.  P.  A.  Mich. 

5.  If  a  company  sells  its  own  bonds  at  a  premium,  is  the 
premium  received  a  legitimate  profit  of  the  company? 

C.  P.  A.  Ohio. 

B.    ACCOUNTING  PROBLEMS 

1.  (a)     A    corporation     issued     First    Mortgage     Bonds 
bearing  interest  at  5%,  dated  January  i,  1917,  to  subscribers 
at  $125.00  for  each  bond,  par  value  $100.00.     The  bonds  are 
to  be  paid  for  in  three  installments:     $25.00  on  February  i; 
$50.00  on  March  i;  and  $50.00  on  April  i.     The  February  i 
and  March  i  installments  have  been  paid  and  the  proper  entries 
made  on  the  cash  book.     You  are  called  in  to  formulate  the 
journal  entries  on  the  two  installments.     How  would  you  make 
them?     There   were   issued   and    sold   $100,000.00    par   value. 

(b)  A  corporation  borrows  $120,000.00  for  a  period  of 
ten  years  to  pay  off  an  existing  loan  at  a  higher  rate  of  interest, 
paying  therefore  in  brokerage  and  costs  $2,750.00.  How  would 
you  treat  this  item  on  the  books?  C.  P.  A.  Ind. 

2.  The  Smith  and  Jones  Manufacturing  Company  issued 
$200,000.00  of  first  mortgage  5O-year,  5%  sinking  fund  bonds 
which  were  marketed  at  98}^,  i%  commission,  and  expended  the 
entire  proceeds  in  the  erection  of  their  plant.     The  discount 
and  commission  were  charged  to  the  Unamortized  Debt  Discount 
and  Expense  accounts,  to  be  subsequently  charged  to  Profit  and 
Loss,  proportionately,  during  the  life  of  the  bonds.     Five  years 
later,  the  company  was  enabled,  owing  to  a  disturbance  in  the 
financial  market,  to  purchase  $50,000.00  of  said  bonds  for  Sink- 
ing Fund  account  at  95. 

Prepare  the  necessary  journal  entries  to  record  correctly 
the  above  transactions  of  the  company.  C.  P.  A.  N.  Y. 

(Note.  You  may  assume  that  the  bonds  were  placed  in  the  hands  of 
a  firm  of  bankers  for  sale.  The  bonds  purchased  for  sinking  fund  account 
were  cancelled  by  the  company.) 


ACCOUNTING  PROBLEMS  191 

3.  The  Standard  Trust  Company  is  appointed  by  the 
Peninsular  Mining  Company  as  Trustee  of  a  Bond  Issue, 
aggregating  $1,000,000.00,  all  Bonds  of  $1,000.00  denomination, 
rate  5%  and  bearing  date  January  I,  1914.  Bonds  mature  in 
ten  equal  annual  installments,  beginning  January  I,  1917,  unless 
previously  converted  or  retired. 

The  issue  is  not  purchased  by  the  Trustee,  but  is  sold  through 
Emory  Davis  &  Company,  Brokers,  the  Company  realizing 
90%  and  accrued  interest  less  the  cost  of  appraisal  of  property, 
printing,  trustees'  expenses,  etc.,  amounting  to  $9,310.80. 

The  entire  issue  was  taken  over,  and  paid  for  by  the  brokers 
on  January  20,  1914. 

Among  other  things  the  trust  deed  provides: 

Bonds  convertible  on  any  interest  date  for  6%  pre- 
ferred stock  at  90%,  at  option  of  holder. 

Bonds  may  be  retired  out  of  surplus  on  any  interest 
date  at  103,  at  option  of  company. 

Sinking  fund  for  payment  of  principal  only  to  be  based 
on  production  of  ore  at  ten  cents  per  ton. 

Trustee  to  charge  %%  of  principal  on  issue,  and  J^% 
on  coupons. 

Interest  payable  January  I  and  July  I. 

The  company's  production  for  three  years  is  assumed  to 
be,  for  the  purpose  of  this  problem,  1,000,000  tons  per  year. 

January  i,  1916 — $100,000.00  are  converted  to  pre- 
ferred stock. 

January    i,    1917 — $200,000.00   are   redeemed   at   103. 

Formulate  all  necessary  entries  in  journal  form  for  books 
of: 

(a)  Standard  Trust  Company, 

(b)  Peninsular  Mining  Company, 

(c)  Emory  Davis  &  Company, 

which  may  be  occasioned  by  the  above  transactions  up  to  and 
including  January   i,   1917. 

C.  P.  A.  Mich. 

(Note.  It  would  be  well  to  review  the  discussion  of  securities  and  the 
accounting  for  sinking  fund  investments  before  preparing  a  solution  to  the 
above  problem.  See  pages  70-76,  Chapter  Five.) 


PRACTICE  DATA 

(Note.  The  following  transactions  are  a  part  of  special  practice 
data  designed  as  a  test  of  your  knowledge  of  the  principles  of  accounting 
and  auditing,  and  of  your  ability  to  apply  the  knowledge  in  actual  practice. 
If  you  have  properly  learned  all  of  the  principles  of  accounting  and  auditing 


192  PUBLIC  ACCOUNTING  AND  AUDITING 

taken  up  in  this  text,  you  should  experience  no  difficulty  in  recording  the  fol- 
lowing transactions  in  proper  form  and  in  preparing  the  necessary  financial 
statements.  Use  ordinary  journal  and  ledger  paper.  If  you  desire,  you  may 
use  analysis  paper  for  special  statements  such  as  the  Working  Sheet.  As 
this  practice  data  is  continued  in  the  next  chapter,  you  should  carefully  pre- 
serve your  working  papers  until  you  are  ready  to  continue  the  work.  You 
may  now  proceed  by  recording  the  following  transactions  in  journal  form.) 

Transaction  No.  1.  The  General  Manufacturing  Com- 
pany was  incorporated  under  the  laws  of  the  state  of  Ohio 
with  an  authorized  capital  stock  of  $4,000,000.00,  consisting 
of  10,000  shares  of  7%  cumulative  preferred  stock  of  the  par 
value  of  $100  each,  and  30,000  shares  of  common  stock  of  the 
par  value  of  $100  each. 

Transaction  No.  2.  Subscriptions  to  the  capital  stock 
were  made  as  follows: 

R.  V.  Williams — 5,000  Shares  Common  and  5,000  Shares 
Preferred  Stock. 

A.  B.  Opfer — 2,000  Shares  Common  and  1,000  Shares  Pre- 
ferred Stock. 

H.  W.   Henry — 1,000  Shares  Preferred  Stock. 
C.  H.  Bowser — 5,000  Shares  Common  Stock. 

Maude  E.  Barnes — 1,500  Shares  Common  and  1,500  Shares 
Preferred  Stock. 

Ruth  E.  Forty — 2,000  Shares  Common  and  1,500  Shares 
Preferred  Stock. 

R.  O.  Wiggins — 5,000  Shares  Common  Stock. 
E.  W.  Atkinson — 5,500  Shares  Common  Stock. 

All  of  the  stock  was  subscribed  for  at  par,  payment  to  be 
made  upon  demand. 

To  further  the  purposes  of  the  new  corporation,  it  is  in- 
tended to  take  over  the  business  owned  and  conducted  by 
R.  V.  Williams  under  the  name  of  the  Williams  Manufacturing 
Company.  The  newly  organized  company  is  to  acquire  all 
the  assets,  excepting  cash,  and  to  assume  all  the  existing 
liabilities  of  the  Williams  Manufacturing  Company.  Mr. 
Williams  is  to  be  allowed  a  price  equal  to  his  present  invest- 
ment with  no  allowance  for  good  will  or  other  intangible  assets. 
Therefore,  Williams'  subscription  to  the  capital  stock  of  the 
General  Manufacturing  Company  is  based  upon  this  agreement. 


Chapter  Thirteen 


NET  WORTH 

Business  Organization.  An  auditor  must  be  familiar 
with  the  different  classes  of  business  organization.  A  business 
may  be  conducted  by  an  individual,  an  association  of  individuals 
known  as  a  copartnership,  or  by  an  artificial  body  created  by 
law  and  known  as  a  corporation. 

1.    ACCOUNTING  THEORY 

The  Sole  Proprietorship.  A  business  conducted  by 
an  individual  is  known  as  a  sole  proprietorship.  The  individual 
contributes  the  capital,  is  entitled  to  the  profits  and  must  stand 
the  losses.  The  Balance  Sheet  must  show  the  investment  or 
capital  and  any  increase  or  decrease  in  the  investment.  By 
reference  to  the  formal  Balance  Sheet  exhibited  on  page  41  of 
Chapter  Three,  it  will  be  seen  that  the  net  worth  of  an  indi- 
vidual should  be  shown  thus: 

(a)  Capital xxxxx .  xx 

(b)  Undistributed  profits  or  deficit. .  .  .   xxxxx. xx 
Naturally,  if  the  business  shows  a  profit  which  has  not  been 

distributed,  it  constitutes  an  addition  to  the  investment,  but  in 
the  case  of  a  deficit  or  net  loss,  there  is  a  deduction  from  the 
investment. 

The  Copartnership.  An  association  of  individuals  in 
business  is  known  as  a  copartnership.  In  this  class  of  business 
organization  the  capital  may  or  may  not  be  contributed  equally 
and  the  profits  and  losses  may  or  may  not  be  shared  equally. 
Hence,  before  the  auditor  can  prepare  the  Balance  Sheet  he 
must  ascertain  the  conditions  of  the  copartnership  agreement. 
It  is  needless  to  say  he  must  also  be  familiar  with  Partnership 
Law.  A  special  section  of  this  course  will  be  devoted  to  part- 
nership accounting,  therefore,  we  will  confine  this  Unit  to 
showing  the  classifications  of  partnership  accounts  in  the  Balance 
Sheet.  This  is  not  shown  clearly  in  the  formal  Balance  Sheet 
in  Chapter  Three.  The  following  is  a  suggested  classification  of 
all  partnership  accounts  for  Balance  Sheet  purposes:  (Assum- 
ing two  partners  and  a  net  profit  for  the  fiscal  period.) 


194  PUBLIC  ACCOUNTING  AND  AUDITING 

(a)  "Y's"  capital xxxxx.xx 

(b)  "X's"  capital xxxxx.xx 

(c)  Add  undistributed  profits xxxxx.xx 

(Assuming  a  deficit  or  net  loss) 

(a)  "Y's"  capital xxxxx.xx 

(b)  "X's"  capital xxxxx.xx 

(c)  Deduct  deficit xxxxx.xx 

It  must  be  remembered  that  this  discussion  is  confined  to 
a  Balance  Sheet  prepared  for  credit  purposes.  Note  that  it 
is  not  necessary  to  show  the  distribution  of  the  profits  or  losses 
although  this  may  be  shown  if  desired.  One  peculiarity  of 
the  Federal  Reserve  Board's  requirements  is  that  a  partner's  per- 
sonal or  drawing  account,  when  a  debit  balance  is  shown,  should 
be  classified  among  the  secured  current  assets,  (see  item  29, 
formal  Balance  Sheet,  page  40,  Chapter  Three) ,  and  Vhen  a  credit 
balance  is  shown,  should  be  classified  among  the  unsecured 
current  liabilities.  (See  item  18,  page  41 ,  Chapter  Three.)  When 
the  account  constitutes  an  asset,  it  is  classified  as  a  current 
asset  but  not  as  a  quick  asset.  This  distinction  is  due  to  the 
fact  that  an  account  receivable  from  a  partner  may  be  slower 
and  more  difficult  to  realize  upon  than  an  account  due  from  a 
customer. 

The  Corporation.  Due  to  the  fact  that  the  first  fifteen 
Units  of  this  course  constitute  instructions  for  a  Balance  Sheet 
audit  of  the  Blank  Manufacturing  Company,  which  is  a  cor- 
poration organized  under  the  laws  of  Indiana,  we  must  give 
more  space  in  this  Unit  to  corporate  organization  than  to  either 
the  individual  or  copartnership  form  of  organization.  No  stress 
will  be  placed  upon  corporate  law  at  this  time,  however. 

Share  Capital.  In  Chapter  Twelve  it  was  shown  that  there 
are  two  classes  of  capital,  share  capital  and  loan  capital.  Any 
capital  borrowed,  by  means  of  mortgages  and  bonds,  for  a  long 
period  of  time  may  be  looked  upon  as  loan  capital,  but  capital 
contributed  by  the  stockholders  of  a  corporation  is  considered 
share  capital.  When  a  corporation  is  organized  there  is  author- 
ized a  certain  issue  of  capital  stock.  The  capital  stock  is  divided 
into  shares  and  ownership  of  these  shares  is  represented  by  stock 
certificates.  Reference  to  the  Chart  on  page  198  will  show 
that,  generally  speaking,  there  are  three  classes  of  corporations — 
municipal,  stock  and  non-stock  corporations.  We  are  con- 
cerned at  this  time  with  stock  corporations. 

Stock  Corporations.  Stock  corporations  may  be  classed 
as  financial,  business  and  public  service.  It  will  be  seen  that 
practically  every  corporation  organized  for  profit  can  be  classed 
as  a  stock  corporation.  By  this  is  meant  that  the  original  capital 
for  financing  the  business  is  raised  principally  by  selling  shares 


STOCK  OF  NO  PAR  VALUE  195 

of  stock.  A  share  of  stock  represents  a  proportionate  interest 
in  the  net  worth  of  a  company.  It  will  readily  be  seen  that  if 
a  company,  with  an  authorized  capital  stock  of  $100,000.00, 
sells  100  shares  of  stock  (par  value,  $100.00)  and  receives  there- 
for $10,000.00  in  cash,  each  share  outstanding  would  represent 
ownership  of  one  hundredth  of  the  net  worth  of  the  company, 
not  one  hundredth  of  the  authorized  capital  stock. 

Stock  Issues.  Stock  may  or  may  not  have  a  specified 
value.  If  the  value  is  specified,  that  value  is  known  as  its  par 
value;  if  no  value  is  specified,  it  is  said  to  be  stock  with  no  par 
value.  Most  stock  bears  a  specified  par  value  which  must  be 
uniform  for  all  the  shares  within  a  certain  class.  The  par  value 
may  and  does  differ  widely.  In  industrial  and  mercantile  com- 
panies, it  is  generally  $100.00,  but  in  the  case  of  mining  com- 
panies the  par  value  is  more  frequently  $1.00.  At  any  rate, 
the  par  value  of  any  issue  of  stock  is  the  amount  specified  in 
the  stock  certificate.  A  stock  certificate  also  specifies  the 
number  of  shares  which  it  represents. 

Stock  of  No  Par  Value.  Stock  of  no  par  value  may  now 
be  issued  in  the  following  states: 

California  Maine 

Delaware  Maryland 

Illinois  New  Hampshire 

Ohio  New  York 

Pennsylvania  Virginia 

When  it  is  considered  that  in  1912,  New  York  passed  the 
first  law  granting  the  right  to  organize  corporations  with  shares 
of  stock  of  no  specified  value,  there  would  seem  to  be  many  de- 
cided arguments  in  favor  of  capital  stock  without  par  value. 
Let  us  see  what  reasons  are  advanced  in  its  favor.  Louis 
Marshall  recently  expressed  his  opinion  as  follows: 

"Eventually  it  will  not  only  become  a  part  of  the  juris- 
prudence of  most  of  the  states' of  the  union,  but  in  twenty  years 
from  now  few  corporations  will  be  organized  on  any  other 
principle. 

"I  believe  it  to  be  the  only  reasonable  method  of  represent- 
ing stock  ownership  in  a  corporation.  The  old  method  of  placing 
an  arbitrary  dollar  mark  on  a  certificate  of  incorporation  led  to 
stock-watering,  the  creation  of  false  values,  and  proved  to  be  an 
easy  medium  for  carrying  out  fraudulent  schemes  and  practices. 
Under  the  new  system  every  share  of  stock  represents  an  aliquot 
interest  in  the  corporate  assets.  Its  value  is  dependent  upon 
the  actual  value  of  the  assets,  and  not  upon  any  fictitious  or 
imaginary  value.  That  is  the  honest  way  of  issuing  stock. 
In  the  past  a  corporation  which  acquired  undeveloped  mining 
property  issued  shares  of  stock  by  the  thousands  and  arbi- 
trarily fixed  the  value  of  the  shares  at  amounts  which  varied 
from  $1.00  to  $100.00  each.  These  corporations  had  capital 
stock  to  the  amount  of  $1,000,000.00  or  $100,000,000.00,  which 


196  PUBLIC  ACCOUNTING  AND  AUDITING 

had  merely  a  potential  value;  but  speculation  was  carried  on 
with  the  idea  that  the  par  value  had  some  relation  to  actual 
value.  It  is  unnecessary  for  me  to  say  that  such  practices 
are  inimical  to  the  public  interest.  It  has  now  become  the 
usual  thing  for  corporations  which  are  honestly  managed  to 
issue  their  stock  without  par  value.  The  experiment  has  proven 
most  satisfactory,  and  bankers  who  at  first  were  skeptical  are 
now  found  to  favor  the  issuance  of  stock  on  this  new  and  reason- 
able theory." 

Accounting  for  Stock  of  No  Par  Value.  From  the 
standpoint  of  the  accountant,  his  work  is  actually  simplified 
to  some  extent.  No  account  with  Unissued  Capital  Stock  is 
necessary.  The  Capital  Stock  account  would  simply  be  credited 
with  the  value  at  which  the  stock  is  issued.  In  other  words, 
the  Capital  Stock  account  shows  the  value  of  the  stock  at  time 
of  issue.  No  accounts  with  stock  discounts  or  premiums  need 
be  kept. 

F.  H.  Hurdman,*  C.  P.  A.,  in  an  address  before  the  annual 
meeting  of  the  Institute  of  Accountants,  held  in  Cincinnati, 
Ohio,  September  16,  1919,  said: 

"In  recording  stock  of  no  par  value  on  the  books  and 
setting  up  values  in  the  statements  of  assets  and  liabilities, 
it  does  not  seem  that  any  difficulties  are  presented.  The  Capi- 
tal account  should  reflect  the  value  at  which  the  stock  was 
issued — whether  for  cash,  property  or  services.  The  only 
other  account  representing  a  measure  of  value  in  the  outstand- 
ing stock,  outside  of  certain  reserve  accounts,  would  be  the  Sur- 
plus account.  In  my  opinion  this  account  should  at  all  times 
represent  undistributed  net  earnings  of  the  corporation. 

"Inasmuch  as  the  Capital  account  will  not  generally  re- 
flect on  its  face  the  number  of  shares  outstanding,  it  will  be 
necessary  to  show  in  the  Capital  account  itself  the  shares  issued. 
It  does  not  become  necessary,  as  in  the  case  of  stock  with  par 
value,  to  carry  any  portion  of  the  proceeds  received  from  its 
sale  to  a  Paid-in-Surplus  account.  Furthermore,  the  fact  that 
stock  may  be  issued  at  varying  values  for  each  share  has  no 
significance  other  than  to  raise  or  lower  the  unit  or  share  value 
for  every  other  share  outstanding.  Each  share  represents  an 
aliquot  part  of  the  entire  capital,  other  than  that  portion  which 
may  be  allocated  to  one  class  of  stock  by  virtue  of  preference. 

"The  number  of  shares  authorized  should  be  noted  on  the 
Capital  Stock  account.  A  separate  account  is,  of  course,  un- 
necessary to  record  this  fact. 

"It  is  probable  that  very  few  cases  will  arise  involving 
donated  treasury  stock,  as  that  is  one  of  the  evil  practices  this 
form  of  legislation  was  designed  to  prevent.  No  reasonable 
object  would  be  attained  by  issuing  stock  of  no  par  value  at  a 

*Of  the  Firm  of  Hurdman  and  Cranstoun,  New  York,  N.  Y. 


CAPITAL  STOCK  197 

nominal  value  and  then  donating  a  portion  of  that  issued  stock 
back  into  the  treasury,  presumably  for  sale  to  provide  working 
capital.  The  incorporators  would  undoubtedly  retain  the 
required  number  of  shares  for  this  purpose  at  the  time  of  in- 
corporation. In  the  event  of  such  a  contingency  arising,  how- 
ever, I  would  suggest  that  the  number  of  donated  shares  be 
carried  in  Treasury  Stock  account  without  any  money  value. 
The  number  of  shares  indicated  by  this  account  would  then  be 
deducted  from  the  issued  shares  shown  in  the  Capital  account, 
in  order  to  show  on  the  statement  the  actual  number  of  shares 
outstanding  in  the  hands  of  the  public,  which  is  the  essential 
fact. 

"When  stock  of  this  description  is  purchased  by  the  com- 
pany and  placed  in  the  treasury,  it  should  be  recorded  in  Treas- 
ury Stock  account  at  its  purchase  price  and  shown  on  the  state- 
ment as  a  deduction  from  Capital  account  at  the  amount  paid 
therefor.  The  number  of  treasury  shares  would  also  be  de- 
ducted from  the  total  shares  outstanding. 

"In  presenting  the  Capital  account  in  the  corporation  state- 
ments the  important  thing  is  to  show  the  number  of  shares 
issued  and  outstanding,  with  the  value  of  these  shares  as  re- 
flected by  the  books  or  the  statements  in  question." 

Market  Value  of  Stock.  The  market  value  of  capital 
stock  may  and  frequently  does  vary  materially  from  its  par 
value.  The  par  value  is  the  amount  specified  in  the  stock 
certificate,  but  the  market  value  is  what  the  stock  actually  sells 
for. 

Capital  Stock  Premium  Account.  Stock  selling  above 
par  is  said  to  sell  at  a  premium.  Such  premium  should  be 
credited  to  an  account  with  Premium  on  Capital  Stock.  This 
represents  a  profit  but  not  an  operating  profit  for  it  cannot  be 
said  that  the  mere  sale  of  stock  above  par  constitutes  an  operat- 
ing profit.  Since  it  does  not  constitute  an  earned  profit  from 
operations,  it  is  not  available  for  dividends.  Financial  organi- 
zations nearly  always  consider  capital  stock  premiums  as  a 
permanent  credit  to  surplus.  Other  classes  of  corporations 
usually  amortize  the  account  by  writing  it  off  over  a  period 
of  years.  This  is  done  by  simply  charging  the  premium  ac- 
count and  crediting  Profit  and  Loss  with  a  proportionate  part 
of  the  premium  each  month  or  year. 

Capital  Stock  Discount  Account.  In  most  states  it 
is  illegal  to  sell  stock  at  a  discount.  Even  where  it  may  be 
done  legally  there  is  a  tendency  to  conceal  the  fact  so  far  as 
the  accounts  are  concerned.  This  is  done  by  charging  the  dis- 
count to  Organization  Expense,  or  by  increasing  the  book 
value  of  property  accounts.  This  policy  is  to  be  condemned 
because  to  increase  the  book  value  of  assets  is  to  inflate  the  net 
worth  or  capital  of  the  concern.  When  this  is  done  the  stock 
(Continued  on  page  199) 


I98 


PUBLIC  ACCOUNTING  AND  AUDITING 


Th» 
Corporation' 


frown* 

Counties 

1.  Municipal  <Citlaa 
(Publlo)  Villages 

[School  Districts 


(a)  Financial 


2.   Stook 
(Private) 


(b)  Business 


I  National  Bania 

State  Banks 
I  Savings  Banks 
•S  Trust  Oompanie* 

Investment  Companies 

Stockbrokers 
JBldg.  &  Loan  Associations 


Fire 
Life 


insurance 

Liability 
[Marine 

Manufacturing 
Publishing 

f&old 

Mining  -<Coal 
[Zino 


Trading 

Transportation  Auto»obil. 


Theatrical 
Hotels 


Service 


(Lawyers 
I  Doctors 
"(Accountants 
Architects 
(Engineers 


fsteam  Railroads 
Electric  Hallways 
(c)  Public  Service < Shipping 

|Eleo.  Light  &  Power 
Water 

(^Telephone 


[idealistic 
Religious 

3.  Non-Stock  ^Charitable 
(Private)  [Benevolent 
Sdusational 
(Cooperative 


NOTE:   The  above  classification  is  intended  to  illustrate  the  various 
olasaes  of  business  enterprises,  both  public  and  private,  that  aaay  be 
organized  in  corporate  form.  No  attempt  has  been  made  to  make  the  list 
exhaustive,  but  it  is  complete  enough  to  be  fairly  illustrative.  It  is 
subject  to  many  variations.  For  instance:  Private  educational  enterprises 
may  be  organized  as  Stock  Corporations,  in  which  case  they  should  be 
classed  under  business  entarprises  and  as  such  are  conducted  for  profit. 
Usually  Ifon-Stock  (Private)  Corporations  are  not  conducted  for  profit. 


ORGANIZATION  EXPENSES  199 

is  said  to  be  "watered."  Kester*,  in  discussing  Discount  on 
Stock,  says: 

"In  the  State  of  New  York  the  stock  of  a  corporation  can- 
not be  sold  below  par.  Where  sale  below  par  is  allowed,  the 
proper  booking  of  the  discount  requires  consideration.  The 
Interstate  Commerce  Commission  requires  that  discounts  or 
premiums  be  shown  on  the  books  under  those  titles,  i.  e.,  Dis- 
count on  Capital  Stock  and  Premium  on  Capital  Stock.  This 
method  is  to  be  commended  as  being  true  to  fact  and  present- 
ing a  full  and  sufficient  record  of  the  facts.  In  the  case  of 
other  concerns  over  whose  accounting  practices  there  is  no 
regulation,  that  method  is  honored  more  in  the  breach  than  in 
the  observance.  A  prevalent  feeling  is  that  the  appearance  on 
a  Balance  Sheet  of  such  an  item  as  discount  on  stock  is  a  serious 
reflection  on  the  standing  of  the  corporation  and  is  to  be  avoided 
in  any  way  possible.  Discount  on  stock  is  not  an  attractive 
item  on  a  Balance  Sheet,  but  there  is  little  justification  for 
such  sentiment  in  those  states  where  the  sale  of  stock  at  a  dis- 
count is  a  perfectly  legitimate  transaction.  The  Balance  Sheet 
ought  to  represent  facts  as  they  are  until  they  change;  then 
the  new  conditions  should  be  shown.  So  long  as  the  discount 
on  stock  remains  a  fact  it  should  be  so  shown.  When  the  dis- 
count has  ceased  to  exist  through  its  absorption  against  premium 
on  stock  or  the  general  surplus,  it  should  no  longer  be  reported 
because  it  is  then  a  matter  of  ancient  history  with  which  the 
present  is  not  concerned. 

"A  favorite  method  of  charging  the  discount  on  stock  to 
organization  expense  is  not  approved,  not  because  it  is  a  mis- 
nomer, for  discount  may  well  be  looked  upon  as  one  of  the  ex- 
penses of  organization,  but  because  it  is  an  item  of  sufficient 
importance  and  interest  to  require  separate  record.  Charging 
the  discount  to  some  asset  account,  when  payment  of  stock  is 
made  by  property  instead  of  by  cash,  is  to  be  severely  con- 
demned. Inflation  of  asset  values  to  cover  up  such  an  item 
cannot  be  justified." 

Organization  Expense  Account.  The  expenses  incurred 
in  the  organization  of  a  corporation  are  usually  charged  to 
this  account  and  then  amortized  over  a  period  of  years.  Such 
expenses  as  the  following  are  usually  charged  to  this  account: 

(a)  Incorporation  fees,  fees  of  attorneys,  accountants,  etc. 

(b)  Promoter's  services,   underwriting    expenses,   cost  of 
printing  and   circulating  prospectuses,   cost  of  soliciting  sub- 
scriptions, cost  of  engraving  and  printing  stock  certificates,  etc. 

Generally  speaking,  all  expenses  actually  incurred  in  the 
organization  of  a  corporation  up  to  the  time  of  actual  operation, 
constitute  proper  charges  to  Organization  Expense. 

The  account  should  undoubtedly  be  written  off  in  a  reason- 
ably short  period  of  time.  It  is  not  considered  good  practice 

*Accounting — Theory  and  Practice,  Volume  Two. 


200  PUBLIC  ACCOUNTING  AND  AUDITING 

in  this  country  to  capitalize  such  expenditures  permanently 
though  it  is  sometimes  done.  Montgomery  says: 

"In  some  respects  sentiment  is  changing  as  to  the  wisdom 
of  spreading  these  expenses  over  more  than  two  years.  The 
best  practice  is  to  charge  off  immediately  everything  which  has 
no  tangible  or  residual  value.  It  is  a  fallacy  to  assume  that 
stock  certificates,  incorporation  expenses,  etc.,  have  any  of  the 
attributes  of  an  asset;  and  so  the  sooner  the  cost  appears  in 
the  Expense  account,  the  better." 

However,  it  is  to  be  noted  that  our  best  authorities  do  not 
agree  with  regard  to  the  time  over  which  these  expenses  should 
be  distributed.  Bennet*  says: 

"Such  expenses  are  absolutely  essential  to  the  creation  of 
the  business,  and  the  first  year  receives  no  more  benefit  from 
the  expenditure  than  the  fifth  or  sixth.  It  would,  therefore, 
seem  more  equitable,  so  far  as  the  statistical  feature  of  book- 
keeping is  concerned,  to  write  such  expenses  off  over  such  a 
period  of  years  as  the  management  may  elect.  Probably  five 
years  would  be  sufficient  for  this  purpose,  in  which  case  one- 
fifth  of  the  total  amount  should  be  charged  off  each  year." 

Classification  of  Capital  Stock.  There  are  many  classes 
of  stock.  We  shall  simply  define  briefly  each  of  the  more  com- 
mon classes. 

Preferred  Stock.  In  an  attempt  to  make  stock  issues  an 
attractive  investment,  often  a  certain  class  of  stock  is  given 
some  preference  over  another  class.  Stock  may  be  preferred  as 
to  assets  or  dividends  or  both.  The  most  common  plan  is  to 
issue  stock  preferred  as  to  dividends.  By  this  is  meant  that 
the  preferred  stockholders  are  entitled  to  their  dividends  before 
the  common  stockholders  share  in  the  profits.  If  stock  is  pre- 
ferred as  to  assets,  in  case  of  dissolution,  the  preferred  stock- 
holders are  entitled  to  their  interest  ahead  of  the  common  stock- 
holders, but  in  no  case  do  the  preferred  stockholders'  claims 
rank  ahead  of  any  outside  claims.  All  preferred  and  general 
outside  creditors  must  first  be  satisfied.  Preferred  stock  may 
be  either  cumulative  or  non-cumulative. 

Cumulative  Preferred  Stock.  Preferred  stock  desig- 
nates a  certain  minimum  rate  of  dividend,  but  if  the  net.  profits 
of  the  company  are  not  sufficient  to  pay  the  dividend,  the  pre- 
ferred stockholders  are  no  better  off  than  the  common  stock- 
holders. If,  however,  the  stock  is  designated  as  cumulative, 
the  holder  is  entitled  to  the  dividend  each  year  or  as  soon  there- 
after as  the  net  earnings  of  the  company  justify  the  distribu- 
tion of  a  dividend.  The  owners  of  preferred  cumulative  stock 
must  be  satisfied  before  the  owners  of  common  stock  may  share 
in  the  profits  at  all. 


*In  his  treatise  on  "Corporation  Accounting." 


STOCK  ISSUES  201 

Non-Cumulative  Preferred  Stock.  Ordinarily,  pre- 
ferred stock  is  cumulative,  but  it  is  not  infrequent  to  find  a 
specification  to  the  effect  that  the  preferred  stock  is  non-cumu- 
lative. In  this  case  the  owners  of  preferred  stock  will  not 
receive  dividends  for  the  current  period  unless  the  net  earnings 
are  sufficient  to  pay  the  rate  of  dividend  specified. 

Common  Stock.  Stock  which  is  evidence  of  ordinary 
ownership  in  the  corporation  is  known  as  common  stock.  After 
preferred  stockholders'  claims  have  been  satisfied  as  to  divi- 
dends, the  common  stockholders  have  a  right  to  the  remainder 
of  the  net  earnings.  In  dissolution  they  are  only  entitled^to 
the  residual  capital,  after  all  other  obligations  have  been  settled. 
It  is  seen,  therefore,  that  common  stock  may  be  either  superior 
or  inferior  to  preferred  stock,  depending  entirely  upon  the 
earning  power  of  the  company. 

Participating  Preferred  Stock.  In  addition  to  specify- 
ing a  minimum  rate  of  dividend,  preferred  stock  may  also 
participate  in  any  dividend  in  excess  of  its  own  specified 
minimum. 

Non-Participating  Preferred  Stock.  When  preferred 
stockholders  do  not  share  in  any  dividends  in  excess  of  the  rate 
specified,  the  stock  is  said  to  be  non-participating.  It  will 
be  seen  that  the  best  possible  class  of  stock,  so  far  de- 
scribed, would  be  participating,  cumulative,  preferred  stock 
— stock  preferred  both  as  to  dividends  and  assets. 

Guaranteed  Stock.  One  company  may  guarantee  the 
stock  of  another  company.  A  large  company  may  enter  into 
a  contract  of  lease  with  a  smaller  company  and  guarantee  a 
certain  rate  of  dividend  to  the  stockholders  of  the  smaller  com- 
pany. Such  a  guarantee  constitutes  a  liability  in  the  form  of 
a  lien  on  the  guarantor  company,  regardless  of  the  amount  of 
the  net  earnings.  Any  stock  said  to  be  guaranteed  by  the 
issuing  company  is  misleading  for  a  company  can  only  legally 
pay  dividends  out  of  earned  profits  and  cannot,  therefore, 
guarantee  its  own  stock. 

Founders'  Stock.  This  class  of  stock  does  not  exist  in 
the  United  States  but  in  England.  Stock  is  sometimes  issued 
to  the  promoters  and  it  is  specified  that  this  stock  shall  share 
dividends  out  of  proportion  to  the  ratio  which  they  bear  to  the 
total  issue  of  common  stock.  For  instance,  this  stock  might  be 
entitled  to  one-half  more  dividends  than  shall  be  given  to  the 
other  stockholders  of  common  stock. 

Debenture  Stock.  The  Public  Service  Commission  of 
New  York  defines  debenture  stocks  as  "those  issued  under 


202  PUBLIC  ACCOUNTING  AND  AUDITING 

contract  to  pay  absolutely  thereon  at  specified  intervals  a  speci- 
fied return."  It  will  be  noted  that  such  stock  is  similar  to 
debenture  bonds,  see  page  180,  Chapter  Twelve.  Debenture  stock 
is  a  debt  of  the  corporation  and  does  not  resemble  stock  as 
used  in  this  country,  hence  has  not  proven  popular  here.  Deben- 
ture stocks  on  account  of  their  being  similar  to  debenture 
bonds  should  be  classified  among  the  fixed  liabilities  in  the 
Balance  Sheet. 

Watered  Stock  has  already  been  referred  to  as  represent- 
ing stock  which  has  a  higher  nominal  value  than  the  true  or 
actual  value  of  the  properties  for  which  it  was  issued.  It  is 
usually  given  in  payment  of  services  or  as  a  bonus  with  bonds. 
Stock  which  has  been  "watered"  tends  to  mislead  the  public 
as  to  its  actual  value. 

Donated  Stock.  Any  stock  donated  by  the  stockholders 
back  to  the  issuing  company  may  be  termed  donated  stock. 
The  object  in  donating  stock  back  to  the  company  is  to  secure 
additional  working  capital  through  its  sale.  Donated  stock  is 
stock  which  has  usually  been  issued  as  fully  paid  to  holders  at 
inflated  values.  At  the  time  it  is  donated  to  the  issuing  com- 
pany, usually  a  transaction  is  entered  on  the  books  at  a  nominal 
figure,  charging  Donated  Stock  account  and  crediting  Working 
Capital  account.  This  donated  stock  is  usually  offered  as 
"treasury  stock  at  less  than  par"  and  represents  assets,  the 
value  of  which  has  been  inflated.  It  may  be  sold  at  par,  or 
at  a  discount  or  premium,  or  may  be  given  away  as  a  bonus 
in  connection  with  the  sale  of  unissued  stock  or  bonds. 

Forfeited  Stock.  When  subscribers  to  capital  stock 
fail  to  make  payment  as  per  agreement,  the  stock  may,  in  some 
cases,  be  declared  forfeited.  Payments  already  made  on  for- 
feited stock  constitute  a  surplus  of  a  permanent  nature.  This 
is  generally  held  not  to  be  available  for  dividends  as  it  does  not 
represent  an  earned  profit. 

Bonus  Stock.  Any  stock  issued  as  a  gift  to  purchasers 
of  preferred  stock  or  bonds  constitutes  bonus  stock.  It  is 
usually  treasury  stock,  otherwise  the  recipient  would  be  liable 
for  the  par  value  of  such  stock  which  fact  might  make  it  an  un- 
welcome gift,  to  say  the  least. 

Treasury  Stock,  strictly  speaking,  represents  stock  which 
has  been  issued  and  later  acquired  through  purchase  by  the 
issuing  company  or  stock  donated  back  to  the  issuing  company 
by  the  stockholders.  There  should  be  a  clear  distinction  be- 
tween unissued  stock  and  treasury  stock.  In  some  states  un- 
issued stock  cannot  be  sold  at  less  than  its  par  value,  but  this 
can  in  no  way  affect  the  sale  of  true  treasury  stock  because 
such  stock  has  already  been  issued  and  may  now  be  reissued 
as  fully  paid  treasury  stock  at  any  price  which  it  may  command. 


PRO-FORMA  ENTRIES  203 

Pro-Forma  Journal    Entries  Incident  to  Capital  Stock 

Transactions 

Opening  Entries.  There  is  a  lack  of  uniformity  with 
regard  to  accounting  practice  in  recording  opening  entries  for 
corporate  organizations. 

Transaction  No.  1.  Let  us  assume  that  the  A.  B.  Company 
has  been  formed  under  the  laws  of  Ohio.  A  charter  has  been 
secured  and  there  is  an  authorized  capital  stock  of  10,000  shares 
with  a  par  value  of  $100.00  each,  being  divided  equally  into 
common  and  preferred  stock. 

At  this  point  the  following  entry  should  be  made: 
Unissued  Capital  Stock,  Common. .  .$500,000.00 
Unissued  Capital  Stock,  Preferred.. .   500,000.00 
Authorized  Capital  Stock, 

Common $500,000.00 

Authorized  Capital  Stock, 

Preferred 500,000.00 

(Explanation.) 

This  entry  is  to  set  up  accounts  with  the  Authorized  Capital 
Stock  and  with  the  Unissued  Capital  Stock.  Some  authorities 
do  not  open  accounts  with  the  Unissued  Capital  Stock  except  in 
case  all  of  the  capital  stock  has  not  been  subscribed  for.  How- 
ever, it  will  readily  be  seen  that  the  method  shown  above  is 
logical  and  practical — it  enables  anyone  to  determine  readily  from 
the  ledger  the  amount  of  the  authorized  stock  of  each  class,  and 
by  comparing  the  Authorized  Capital  Stock  accounts  with  the 
Unissued  Stock  accounts,  it  is  a  simple  matter  to  determine  the 
amount  of  stock  of  each  class  actually  outstanding. 

Transaction  No.  2.  Subscriptions  to  the  capital  stock  have 
been  made  as  follows: 

A — 1,000  Shares  Common  and  1,000  Shares  Preferred  Stock. 
B — 500  Shares  Common  and  500  Shares  Preferred  Stock. 
C — i  ,000  Shares  Common  Stock. 
D — 100  Shares  Preferred  Stock. 

E — 25  Shares  Common  and  25  Shares  Preferred  Stock. 
These  subscriptions  to  the  capital  stock  had  all  been  secured 
at  the  time  the  corporation  was  formed,  but  the  stock  has  not 
been  paid  for  nor  issued,  hence  the  transaction  may  be  set  up 
as  follows: 

Subscriptions  to  Capital  Stock, 

Common $252,500.00 

Subscription**  to  Capital  Stock, 

Preferred 162,500.00 

Capital  Stock  Subscribed, 

Common $252,500.00 

Capital  Stock  Subscribed, 

Preferred 162,500.00 

(Explanation.) 

Transaction  No.  3.    Upon  call  the  subscribers  to  the  capital 
stock  make  the  following  settlement : 


204  PUBLIC  ACCOUNTING  AND  AUDITING 

A  pays  for  his  stock  in  full  by  giving  title  to  certain 
real  estate. 

B,  C  and  D  pay  for  their  stock  in  cash. 

E  gives  a  30  day  note  in  payment  of  his  stock.  Stock 
certificates  are  issued  to  all  subscribers. 

This  transaction  may  be  recorded  as  follows: 

(a) 

Real  Estate $200,000.00 

Cash 210,000.00 

Notes  Receivable 5,000.00 

Subscriptions  to  Capital  Stock, 

Common $252,500.00 

Subscriptions  to  Capital  Stock, 

Preferred 162,500.00 

(Explanation.) 

(b) 

Capital  Stock  Subscribed,  Common. $252, 500.00 
Capital  Stock  Subscribed,  Preferred.    162,500.00 
Unissued  Capital  Stock, 

Common $252,500.00 

Unissued  Capital  Stock, 

Preferred 162,500.00 

(Explanation.) 

It  will  be  seen  from  the  above  entries  that  as  soon  as  the 
stock  previously  subscribed  for  has  been  issued,  it  is  necessary 
to  make  an  entry  crediting  the  Unissued  Stock  accounts.  This 
is  necessary  because  the  difference  between  the  Unissued  Stock 
accounts  and  the  Authorized  Stock  accounts  should  always 
represent  the  exact  amount  of  stock  issued  and  outstanding. 

2.    AUDITING  THEORY 

Quoting  from  the  Federal  Reserve  Bulletin: 

Capital  Stock.  "As  a  rule  trust  companies  are  the  trans- 
fer agents  for  the  capital  stock  of  large  corporations  and  for  veri- 
fication purposes  it  is  sufficient  to  obtain  letters  from  them  certi- 
fying to  the  capital  stock  outstanding. 

"Where  companies  issue  their  own  stock,  the  stock  regis- 
ters and  stock  certificate  books  should  be  examined  and  com- 
pared with  the  lists  of  outstanding  stockholders. 

"On  the  Balance  Sheet  each  class,  if  more  than  one,  of  stock 
must  be  stated,  giving  amount  authorized,  issued,  and  in  treasury, 
if  any.  In  the  case  of  companies  with  cumulative  preferred 
stocks  outstanding  a  note  must  be  made  in  Ae  Balance  Sheet 
of  the  dividends  accrued  but  not  yet  declared. 

"If  stock  has  been  sold  on  the  installment  plan,  the  auditor 
should  ascertain  that  the  calls  have  been  promptly  met  and 
whether  any  are  in  arrears.  If  special  terms  have  been  ex- 
tended to  any  stockholder,  approval  of  the  board  of  directors 
is  necessary  and  the  minutes  should  be  examined  accordingly. 

"If  any  stock  has  been  sold  during  the  period  under  audit, 
the  auditor  should  verify  the  proceeds  of  the  sales." 


THEORY  QUESTIONS  205 

A.    THEORY  QUESTIONS 

1.  (a)     Name  the  various  forms  of  Capital  Stock,  with  full 
explanation. 

(b)     What  is  the  meaning  of  Watered  Stock  and  how  should 
it  appear  on  the  books?  C.  P.  A.  Mich. 

2.  How  is  the  value  of  capital  stock  determined? 

C.  P.  A.  Ark. 

3.  Mention  and  explain  two  common  views  concerning 
the  treatment  of  donated  capital  stock.  Inst.  Ex.  1918. 

4.  In  making  up  a  Balance  Sheet  should  the  capital  in- 
vested   be    included    in    the    liabilities?     State    your   reasons. 

C.  P.  A.  Ohio. 

5.  How  should  the  losses  on  shares  of  stock  issued  at  a 
discount  be  dealt  with  in  the  accounts  of  a  corporation? 

C.  P.  A.  Ind. 

6.  What  is  treasury  stock,  and  state  the  difference,  if  any, 
between  that    and  stock  authorized  but  not  issued.     At  what 
price  may  either  be  sold?     How  should  they  appear  on  the 
books  of  account?  C.  P.  A.  Ind. 

7.  In  its  prospectus  a  corporation  represents  that  it  has 
an  issue  of  "cumulative,  non-voting,  non-participating,  six  per 
cent  preferred  stock". 

Give  your  interpretation  of  this  expression. 

C.  P.  A.  Mass. 

8.  What  are  organization  expenses?     How  are  they  to  be 
treated  in  accounts?     At  what  point  do  expenses  cease  to   be 
organization  expenses  and  become  operating  expenses? 

Inst.  Ex.  1918. 

9.  To  what  extent  may  the  "organization  expenses"  of 
a  corporation  be  regarded  as  a  permanent  asset  and  how  should 
this  account  accordingly  be  dealt  with?  C.  P.  A.  Me. 

10.  Is  the  deficiency  in  the  early  years  of  a  corporation's 
activities  (whether  an  actual  loss  or  a  deficiency  between  the 
earnings  and  the  normal  rate  of  return)  similar  to  organization 
expenses?     How  should  such  deficiencies  be  treated  in  the  ac- 
counts?    To  what  extent  is  such  a  deficiency  similar  to  interest 
paid  during  construction?     Should  such  deficiencies  be  carried 
on  the  Balance  Sheet?     If  so,  should  they  be  written  off,  and 
how  and  when?     May  the  deficiencies  representing  the  differ- 
ence between   actual  earnings  and   normal   rate  of  return   be 
capitalized,  in  the  strict  sense  of  having  capital  stock  issued 
to  a  corresponding  sum?     State  clearly  just  who  is  affected, 
and  how,  by  the  different  methods  of  treating  the  items  mention- 
ed above.  Inst.  Ex.  1917. 


206  PUBLIC  ACCOUNTING  AND  AUDITING 

B.     ACCOUNTING  PROBLEMS 

1.  A  Massachusetts  corporation  temporarily  in  need  of 
funds  makes  the  following  arrangement  with  three  of  its  directors. 
They  individually  pledge  their  stock,  par  value  $15,000,  $10,000, 
and  $5,000,  and  receive  loans  of  $7,500,  $5,000,  and  $2,500, 
with  which  they  purchase  new  stock  at  par.    It  is  their  intention, 
when  the  loans  are  paid  by  the  corporation  to  return  this  $15,000 
worth  of  stock. 

(a)  May  this  stock  be  purchased  by  the  company? 

(b)  What  should  be  the  entries  on  the  books  of  the 
corporation?  C.  P.  A.  Mass. 

2.  A  company  organized   with   $1,000,000  capital   stock 
which  it  placed  at  par,  and  $1,000,000  5  per  cent  bonds  Xvhich 
it  sold  at  90,  this  being  a  6  per  cent  basis.    It  paid  to  contractors, 
etc.,  for  construction  $1,800,000  and  this  amount  of  investment 
ran,  on  the  average,  for  one  year  before  the  property  was  ready 
for  operation.    When  operation  began  the  company  had  therefore 
paid  one  year's  interest  on  the  issue  of  bonds.     No  dividends 
were  paid  on  the  stock.     In  addition  to  the  sum  named  above 
the  company  also  paid  $10,000  for  legal  expenses  in  connection 
with  incorporation  and  $5,000  for  franchise  and  other  fees. 

How  should  the  accounts  appear  when  the  property  was 
ready  for  operation?  Formulate  journal  entries  and  post  to 
skeleton  ledger  accounts.  Inst.  Ex.  1917. 

3.  A  corporation  having  issued  its  capital  stock  at  par 
buys  1,000  shares  at  95.     It  later  sells  500  of  these  shares  at 
98,  and  300  at  85,  and  200  at  101.     Give  the  journal  entries 
covering  these  transactions. 

How  should  the  items  appear  on  the  Balance  Sheet  immedi- 
ately after  purchasing  the  stock,  and  immediately  after  each 
of  the  sales?  Inst.  Ex.  1917. 

4.  In  auditing  the  Smith  Manufacturing  Company's  books, 
you  find  in  going  through  their  minutes  that  a  resolution  was 
passed  to  give  away  one  share  of  common  stock  with  every 
share  of  preferred  stock  sold.     At  the  end  of  their  fiscal  year, 
which  period  you  are  asked  to  audit,  their  books  show  as  follows: 

Real  Estate  and  Buildings  .........  $  83,872.88 

Cash  on  Hand  in  Bank  ............        1,063.06 

Machinery  and  Tools  ..............      10,000.00 

Fixtures  .........................          452.18 

Unearned  Insurance  ...............  160.94 

Office  Supplies  ....................          397-86 

Manufactured  Goods  on  Hand  ......      10,000.00 

Accounts  Receivable  ..............      16,840.62 

Capital  Stock,  Preferred  ............  $  37,500.00 

Bills  Payable  .....................  13,100.00 

Accounts  Payable  .................  14,601.43 

Mortgage  Loan  on  Real  Estate  .....  35,000.00 

Profit  and  Loss  Account  ...........  22,586.11 


What  comments  would   you   make   to   the  Smith   Manu- 
facturing Company?  C.  P.  A.  Ark. 


ACCOUNTING  PROBLEMS  207 

5.  A  corporation  organizes  under  the  laws  of  Michigan 
to  conduct  a  manufacturing  business.  Authorized  capital 
$400,000.00,  half  each  common  and  preferred  stock,  shares 
$100.00.  Five  incorporators  subscribe  for  ten  shares  each  of 
common  stock  at  face  value.  John  Smith  purchases  from  three 
manufacturing  companies,  their  complete  plants  for  $395,000.00 
and  transfers  said  plants  to  the  incorporated  company  for  the 
remaining  $395,000.00  of  common  and  preferred  stock  and 
$150,000.00  of  first  mortgage  5%  bonds  out  of  a  total  issue  of 
bonds  of  $200,000.00,  leaving  $50,000.00  of  bonds  in  the  treasury. 

Make  opening  journal  entries  and  Trial  Balance  showing 
the  company's  condition  after  the  transaction. 

C.  P.  A.  Mich. 
PRACTICE  DATA 
(Continued  from  Chapter  Twelve) 

Transaction  No.  3.  As  has  been  stated  in  Transaction 
No.  2,  the  General  Manufacturing  Company  is  to  acquire  all 
the  assets  excepting  cash  and  to  assume  all  the  liabilities  of  the 
Williams  Manufacturing  Company.  With  this  in  view  a  firm 
of  Certified  Public  Accountants  was  employed  to  make  a  Bal- 
ance Sheet  audit  of  the  books  of  the  latter  company.  The 
present  investment  of  Williams,  as  shown  in  the  accompanying 
Balance  Sheet  after  deducting  the  cash,  is  $1,601,670.00.  In 
Transaction  No.  2,  Williams  subscribed  for  5,000  shares  common 
stock  and  5,000  shares  preferred  stock  of  the  General  Manu- 
facturing Company.  Certificates  for  this  stock  have  now  been 
issued  to  Williams.  The  balance  due  Williams  is  to  be  paid 
later  by  issuing  bonds.  A  preliminary  agreement  has  been 
made  whereby  Williams  will  purchase  the  entire  bond  issue. 
For  the  present,  therefore,  an  account  with  Williams  is  per- 
mitted to  stand  open  until  such  time  as  the  details  of  the  bond 
issue  may  be  completed.  The  Balance  Sheet  of  the  Williams 
Manufacturing  Company,  as  certified  by  the  accountants, 
appears  as  follows: 

THE  WILLIAMS  MANUFACTURING  COMPANY 
Balance  Sheet—Dec.  31,  1919 

ASSETS 

Bank  Balance $      68,000.00 

Imprest  Cash 1,330.00 

Accounts  Receivable 89,256.00 

Notes  Receivable 24,340.00 

Merchandise  Inventory 223,258.00 

Land 500,000.00 

Buildings 690,000.00 

Machinery,  Tools  and  Equipment. . .    1,130,000.00 

Office  Furniture  and  Fixtures 8,160.00 

Deferred  Administrative  Expenses. . .  9,279.00 

Total  Assets $2,743,623.00 

(Concluded  on  next  page} 


208  PUBLIC  ACCOUNTING  AND  AUDITING 

LIABILITIES 

Accounts  Payable $  408,000.00 

Notes  Payable,  Banks 545,000.00 

Notes  Payable,  Trade 57,000.00 

Notes  Receivable  Discounted  (Contra)  23,623.00 

Accrued  Pay  Roll  30,000.00 

Accrued  Salaries 9,000.00 


Total  Liabilities $1,072,623.00 

R.  V.  Williams'  Present  Investment.  1,671,000.00 


$2,743,623.00 

Transaction  No.  4.  C.  H.  Bowser  and  R.  O.  Wiggins 
pay  their  subscriptions  to  the  capital  stock  by  conveying  to  the 
company  title  to  patents  valued  at  $1,000,000.00.  Stock  cer- 
tificates are  issued  to  each. 

Transaction  No.  5.  Following  the  organization  of  the 
General  Manufacturing  Company,  it  was  decided  to  issue  bonds 
as  follows:  (Bonds,  par  value,  $1,000  each.)  * 

First  Mortgage  Bonds,  5%,   20  years,  $120,000.00 
Second  Mortgage  Bonds,  6%,  15  years,  $398,000.00 
Debenture  Bonds,  5%,  10  years,  $153,000.00 

R.  V.  Williams  purchased  the  entire  bond  issue  at  par, 
thereby  cancelling  his  account  against  the  company,  he  paying 
the  difference,  $69,330.00,  in  cash. 


Chapter  Fourteen 


PROFIT  AND  LOSS 

A  Balance  Sheet  audit  comprehends  the  preparation  of  a 
Profit  and  Loss  statement.  When  the  Balance  Sheet  is  pre- 
pared, after  proper  verification  of  all  stated  and  unstated  assets 
and  liabilities,  it  will  show  either  a  surplus  or  a  deficit.  If  the 
net  worth  has  increased  during  the  fiscal  period,  over  and  above 
any  additions  to  the  investments,  there  has  been  an  addition  to 
the  surplus  or  undivided  profits.  On  the  other  hand,  if  the  net 
worth  has  decreased  during  the  fiscal  period,  after  properly 
considering  any  withdrawals  from  the  investment,  there  has 
been  a  deduction  from  the  amount  of  the  surplus  existing  at 
the  beginning  of  the  fiscal  period  and  if  the  amount  of  the  assets 
are  actually  less  than  the  amount  of  the  liabilities  an  actual 
deficit  will  exist. 

In  as  much  as  no  conclusions  can  be  definitely  arrived  at  with 
regard  to  the  causes  for  any  changes  in  the  net  worth,  from  the 
Balance  Sheet,  it  is  necessary  to  prepare  a  Profit  and  Loss 
statement.  The  client  will  not  be  satisfied  to  simply  be  in- 
formed that  his  business  has  been  conducted  at  a  profit  or  loss 
amounting  to  a  certain  sum,  but  will  naturally  be  even  more 
concerned  in  knowing  how  these  facts  were  ascertained.  How 
were  profits  made  or  how  were  losses  incurred?  are  natural 
questions. 

To  prepare  an  intelligent  statement  of  profits  and  losses  will 
require  familiarity  with  the  legal  and  economic  phases  of  in- 
come and  expense  accounts,  and  ability  to  state  the  transactions 
in  an  intelligent  manner.  This  implies  ability  to  analyze  the 
nominal  accounts  and  to  present  the  results  so  that  the  proper 
information  is  conveyed  to  the  client  in  the  best  possible  form. 

In  connection  with  the  analyzing  of  income  and  expense 
accounts,  and  the  best  form  for  presenting  the  results,  we  will 
again  refer  to  the  Federal  Reserve  Bulletin  on  "Uniform 
Accounting." 

Surplus.  "The  auditor  should  give  consideration  to  the 
surplus  at  the  beginning  of  the  period.  This  item  represents 
the  accumulated  profits  prior  to  the  beginning  of  the  fiscal 
period  under  review,  and  should  be  compared  with  the  surplus 
shown  on  the  Balance  Sheet  of  the  previous  year,  and  with 
the  ledger  account,  to  see  that  it  corresponds,  and  if  it  does  not, 
a  reconciliation  statement  should  be  prepared  giving  full  de- 
tails of  the  differences. 

209 


2io  PUBLIC  ACCOUNTING  AND  AUDITING 

Profit  and  Loss.  "The  auditor  should  obtain  the  Profit 
and  Loss  statement  for  three  years,  at  least,  including  the 
period  under  audit,  and  after  verifying  them  by  comparison 
with  the  ledger  account,  prepare  a  statement  in  comparative 
form.  This  comparison  will  furnish  valuable  information  to 
the  banker  as  to  the  past  progress  of  the  concern  under  audit. 

"While  it  would  be  impracticable  in  an  ordinary  Balance 
Sheet  audit,  and,  at  the  same  time,  somewhat  useless  to  make 
a  detailed  check  of  all  the  transactions  entering  into  the  com- 
position of  the  Profit  and  Loss  account,  there  are  certain  main 
principles  to  be  kept  in  view  which  are  briefly  outlined  below: 

Sales.  "Whenever  it  is  possible,  the  quantities  sold  should 
be  reconciled  with  the  inventory  on  hand  at  the  beginning  of 
the  period,  plus  the  production,  or  purchases,  during  the  period, 
less  the  inventory  on  hand  at  end  of  the  period. 

"Where  a  good  cost  and  accounting  system  is  in  force,  the 
sales  records  will  very  probably  be  in  good  shape,  but  neverthe- 
less, the  auditor  should  satisfy  himself  from  the  shipping  records 
that  the  sales  books  were  closed  on  the  last  day  of  the  fiscal  year, 
and  that  no  goods  shipped  after  that  date  are  included  in  the 
transactions. 

"When  an  audit  is  being  made  for  the  first  time,  the  auditor 
should  satisfy  himself  that  the  sales  at  the  beginning  of  the 
period  were  recorded  in  accordance  with  the  dates  of  shipments. 
Such  verifications  can  be  made  conveniently  by  a  direct  com- 
parison of  the  shipping  memoranda  with  the  invoices  billed. 

"Allowances  to  customers  for  trade  discounts,  outward 
freights,  reductions  in  prices,  etc.,  should  be  deducted  from  the 
sales  in  the  Profit  and  Loss  account,  as  the  amount  of  net  sales 
is  the  only  figure  of  interest  to  the  bankers. 

"The  future  bookings  at  the  close  of  the  fiscal  year  should  be 
looked  into,  as  a  comparison  of  orders  on  hand  with  corresponding 
periods  of  other  years  furnishes  the  bankers  with  an  idea  of  the 
concern's  business  outlook. 

Cost  of  Sales.  "The  inventory  at  the  beginning  of  the 
period,  plus  purchases  during  the  period,  less  inventory  at  the 
end  of  period,  gives  the  cost  of  sales.  In  a  manufacturing  con- 
cern the  factory  cost  of  production  takes  the  place  of  purchases. 
These  items  will  have  already  been  verified  in  auditing  the 
Balance  Sheet,  but  nevertheless  care  should  be  taken  to  see  that 
this  heading  has  not  been  made  a  dumping  ground  for  charges 
which  would  be  more  properly  embraced  under  the  heading  of 
special  charges.  The  composition  of  the  items  entering  into 
the  cost  of  sales  should  be  traced  in  totals  into  the  cost  ledgers 
or  accounts. 

Gross  Profit  on  Sales.  "This  is  obtained  by  deducting 
the  cost  of  sales  from  the  net  sales.  The  ratio  of  gross  profits 
to  net  sales  should  be  calculated  and  compared. 


PROFIT  AND  LOSS  211 

Selling,     General     and     Administrative     Expenses. 

"Under  these  general  headings  should  be  set  down  the  expenses 
itemized  to  correspond  with  the  titles  of  the  ledger  accounts 
kept  in  each  division.  In  checking  the  totals  of  each  account 
with  the  statement  for  the  period  under  audit,  special  atten- 
tion to  credits  in  these  accounts  should  be  given  to  see  that  none 
have  been  made  for  the  sale  of  capital  assets  and  for  other  items 
which  should  not  appear  in  expense  accounts.  The  percentages 
of  the  totals  of  each  division  and  of  the  aggregate  total  to  net 
sales  should  be  calculated  for  each  year  for  comparison . 

Net  Profit  on  Sales.  "This  is  obtained  by  deducting 
the  aggregate  total  of  the  selling,  general,  and  administrative 
expenses  from  the  gross  profit  on  sales,  and  shows  the  net  earn- 
ings of  the  concern  on  its  real  business.  Ratio  to  sales  should 
be  calculated  for  each  year  for  comparison. 

Other  Income.  "Under  this  heading  is  embraced  any  in- 
come that  may  be  derived  from  sources  outside  of  sales,  such 
as  income  from  investments,  interest,  discounts,  etc.  Schedules 
should  be  prepared  of  each  item,  and  the  auditor  should  satisfy 
himself  of  their  accuracy  and  of  the  propriety  of  including  them 
as  income. 

Deductions  from  Income.  "Under  this  heading  are 
grouped  such  items  as  interest  on  bonded  debt,  interest  on  notes 
payable,  etc.  The  same  procedure  of  verification  as  nuthe 
case  of  other  income  should  be  followed. 


Net  Income — Profit  and  Loss.  "Adding  other  income 
to  gross  income  and  deducting  deductions  from  income  gives  the 
net  income  or  profit  and  loss  for  the  period,  which  is  the  amount 
that  should  be  carried  to  the  Surplus  account. 

Surplus  Additions  and  Deductions.  "Items  of  un- 
usual or  extraordinary  profit  which  do  not  belong  strictly  to  the 
period  under  audit,  or  cannot  be  said  to  be  the  legitimate  result 
of  the  ordinary  transactions  of  the  concern,  should  be  entered 
here  and  verified  with  the  Surplus  account.  Similarly,  deductions 
should  be  treated.  Also  dividends  declared  should  be  entered 
in  the  Surplus  account  and  as  an  item  under  this  caption,  inas- 
much as  it  is  the  usual  custom  to  declare  dividends  'from  net 
earnings  and  surplus.'  After  adding  special  credits  to  and  de- 
ducting special  charges  from  the  net  income,  we  have  the  total 
profit  and  loss  for  the  whole  period  from  all  sources  which,  added 
to  the  surplus  balance  at  the  beginning  of  the  period,  gives  us 
the  surplus  at  the  end  of  the  period,  which  should  agree  with  the 
surplus  as  stated  on  the  Balance  Sheet. 


212  PUBLIC  ACCOUNTING  AND  AUDITING 

General.  "These  instructions  cover  audits  of  small  or 
medium  sized  concerns.  In  large  concerns  having,  for  instance, 
tens  of  thousands  of  accounts  or  notes  receivable,  the  detail  pro- 
cedure suggested  would  be  impracticable,  and  internal  check 
should  make  it  unnecessary.  In  such  cases  only  tests  can  be 
made,  but  the  auditor  must  always  be  prepared  to  justify  his 
departure  from  a  complete  program  by  showing  that  the  pur- 
poses sought  to  be  accomplished  thereby  have  been  adequate- 
ly effected  by  his  work. 

"Any  extensive  clerical  work,  such  as  preparations  of  lists 
of  notes  receivable,  etc.,  should  be  performed  by  the  client's 
staff,  so  as  to  avoid  unnecessary  employment  of  professional 
staff  in  merely  clerical  work  and  consequent  undue  expense." 

THE  PROFIT  AND  LOSS  STATEMENT 

A  Profit  and  Loss  statement  should  be  submitted  with  the 
income  and  expenditures  classified  under  appropriate  captions, 
and,  if  possible,  this  statement  should  show  the  operations  in 
comparative  form.  If  comparative  figures  for  several  years  are 
submitted,  the  accountant  must  satisfy  himself  that  the  figures 
for  all  periods  are  prepared  on  the  same  basis.  Instances  are 
frequent  where  concerns  make  a  liberal  provision  for  deprecia- 
tion, etc.,  in  prosperous  years,  and  reduce,  or  even  eliminate,  all 
depreciation  in  years  during  which  business  is  poor  and  profits 
small.  Occasionally,  a  basis  of  inventory  valuation  is  adopted 
differing  materially  from  the  basis  used  the  year  before,  and  some 
concerns  show  a  tendency  to  charge  to  capital  during  lean  years, 
items  of  a  nature  which  are  absorbed  in  operating  expenses 
during  prosperous  years. 

Since  the  Income  and  Excess  Profits  Tax  Laws  became 
effective,  business  men  are  liable  to  set  up  excessive  depreciation 
and  to  charge  to  operating  expense,  expenditures  which  should 
have  been  capitalized.  An  instance  recently  came  to  the  writer's 
attention  wherein  a  concern  charged  to  operating  expenses,  exten- 
sive improvements  on  grounds  surrounding  the  plant,  such  as 
building  of  fences,  driveways,  sidewalks,  parks,  etc.,  costing 
thousands  of  dollars,  not  a  cent  having  been  capitalized. 
When  the  books  of  the  company  were  audited  by  Income  Tax 
inspectors  the  expenditures  were  analyzed,  those  representing 
improvements  that  increased  the  value  of  the  property  were 
charged  to  capital  and  not  allowed  as  deductions  from  income; 
hence,  the  company  was  assessed  for  additional  taxes. 

Increases  or  decreases  in  the  sales  should  be  carefully  scru- 
tinized. A  recent  audit  of  a  manufacturing  concern  disclosed 
a  substantial  increase  in  sales  when  compared  with  the  operations 
of  the  preceding  year,  but  a  thorough  investigation  revealed 
the  fact  that  the  increase  was  due  entirely  to  large  orders  having 
been  received  from  two  new  customers.  Had  this  new  business 
not  been  obtained,  the  sales  for  the  last  year  reported  on 
would  have  shown  an  actual  decrease. 


MANUFACTURING  STATEMENTS 


213 


The  Profit  and  Loss  statement  should  be  so  arranged  as  to 
reflect  the  actual  results  of  the  period,  and  the  figures  shown 
thereon  should  not  need  any  explanation  or  qualification.  The 
Model  Statement  of  Profit  and  Loss,  shown  on  page  214  of  this 
Chapter,  is  a  comparative  statement  for  a  period  of  three  years. 
It  would  be  quite  impossible  to  show  a  form  of  statement  that 
would  fit  every  business.  The  form  shown  is  general  and  at 
the  same  time  is  simple  enough  to  be  easily  comprehended.  It 
is  based  on  Federal  Reserve  Board  requirements. 

In  a  manufacturing  enterprise  a  special  statement  of  factory 
operations  showing  cost  of  goods  manufactured  and  sold  should 
also  be  prepared.  The  cost  of  sales  as  arrived  at  from  the  state- 
ment of  factory  operations,  may  be  used  in  arriving  at  the  gross 
profit  on  sales  in  the  Profit  and  Loss  statement.  A  model 
statement  showing  cost  of  goods  manufactured  and  sold  is 
exhibited  below. 


Material 

Inventory,  beginning  of  period  , 

Material  purchased 

Freight  and  cartage  inward . .  . 


Cost  of  Accountable  Material 

Deduct  inventory,  ending  of  period .  . 


^xxxxx.xx 
$  xxxxx.xx 

XXXXX . XX   XXXXX . XX 

XXXXX . XX 
XXXXX . XX 


Cost  of  Material  Consumed 

Add: 

Labor 

Manufacturing  expenses: 

Depreciation  on  buildings $  xxxxx.xx 

Depreciation  on  machinery xxxxx.xx 

Factory  expense xxxxx. xx 

Fuel xxxxx .  xx 

Insurance,  bldgs.  and  machinery. .  xxxxx.xx 

Repairs  to  building xxxxx .  xx 

Repairs  to  machinery xxxxx.xx 

Taxes  on  real  estate  .  .  xxxxx.xx 


Total  manufacturing  expenses 

Add  woi  k  in  process,  beginning  of  period .  . 

Deduct  woik  in  process,  ending  of  period.  . 

Cost  of  Goods  Manufactured 

Add   inventory   finished   goods,    beginning 
of  period 


Deduct   inventory   finished  goods,   ending 
of  period 

Cost  of  Sales.  . 


xxxxx.xx 


xxxxx . xx  xxxxx . xx 


XXXXX . XX 


XXXXX . XX 
XXXXX . XX 


XXXXX . XX 

xxxxx.xx 

XXXXX . XX 

Sxxxxx . xx 


(Model  Statement  of  Cost  of  Goods  Manufactured  and  Sold) 


214 


PUBLIC  ACCOUNTING  AND  AUDITING 

Year  ending — 


Gross  sales 

Less  outward  freight,;allowances  and  returns 


Net  'sales . 


Inventory  beginning  of  year . 
Purchases,  net 


Less  inventory  end  of  year. 

Cost  of  sales 

Gross  profit  on  sales 


Selling  expenses  (itemized  to  correspond  with 
ledger  accounts  kept) 


Total  selling  expense . 


General   expenses    (itemized   to  correspond 


with  ledger  accounts  kept) 
Total  general  expense . 


Administrative  expenses  (itemized  to  corres- 
pond with  ledger  accounts  kept) . . . 

Total  administrative  expense 

Total  expenses 

Net  profit  on  sales 


Other  income: 

Income  from  investments 

Interest  on  notes  receivable,  etc. 


Gross  income . 


Deductions  from  income: 

Interest  on  bonded  debt. . 
Interest  on  notes  payable. 


Total  deductions. 


Net  income — profit  and  loss 

Add  special  credits  to  profit  and  loss 

Deduct  special  charges  to  profit  and  loss 


Profit  and  loss  for  period. 
Surplus  beginning  of  period .  .  . 


Dividends  paid 

Surplus  ending  of  period . 


19— 

19— 

19— 

$xxxx.xx 
xxxx.xx 

Sxxxx.xx 
xxxx.xx 

$xxxx.xx 
xxxx.xx 

xxxx.xx 

xxxx.xx 

xxxx.xx 

xxxx.xx 
xxxx.xx 

xxxx.xx 
xxxx.xx 

xxxx.xx 
xxxx.xx 

xxxx.xx 
xxxx.xx 

xxxx.xx 
xxxx.xx 

xxxx.xx 
xxxx.xx 

XXXX  .  XX 

XXXX  .  XX 

XXXX  .  XX 

XXXX.  XX 

XXXX  .  XX 

xxxx.xx 

xxxx.xx 

xxxx.xx 

xxxx.xx 

xxxx.xx 

xxxx.xx 

xxxx.xx 

xxxx.xx 

xxxx.xx 

xxxx.xx 

xxxx.xx 

XXXX  .  XX 

xxxx.xx 

xxxx.xx 

XXXX  XX 

xxxx.xx 

xxxx.xx 

xxxx.xx 

XXXX  .  XX 

xxxx.xx 

XXXX  .  XX 

xxxx.xx 

xxxx.xx 

XXXX  .  XX 

xxxx.xx 

XXXX  .  XX 

xxxx.xx 

xxxx.xx 
xxxx.xx 

xxxx.xx 
xxxx.xx 

xxxx.xx 

XXXX  .  XX 

xxxx.xx 

xxxx.xx 
xxxx.xx 

xxxx.xx 
xxxx.xx 

xxxx.xx 
xxxx.xx 

XXXX  .  XX 

xxxx.xx 

xxxx.xx 

xxxx.xx 
xxxx.xx 
xxxx.xx 

xxxx.xx 

XXXX  .  XX 

xxxx.xx 

xxxx.xx 

XXXX  .  XX 

xxxx.xx 

xxxx.xx 
xxxx.xx 

xxxx.xx 
xxxx.xx 

XXXX  XX 
XXXX  .  XX 

xxxx.xx 
xxxx.xx 

xxxx.xx 
xxxx.xx 

xxxx.xx 
zxxx.xx 

Sxxxx  xx 

Sxxxx  xx 

$XXXX  .  XX 

(Model  Comparative  Statement  of  Profit  and  Loss) 


THE  WORKING  PAPERS  2i5 

HOW  TO  END  AN  AUDIT 

Completing  an  Audit.  When  an  audit  has  been  com- 
pleted, the  juniors  should  hand  their  working  papers  to  the 
senior.  The  senior  then  assembles  them  and,  before  leaving  the 
office  of  the  client,  he  should  check  over  the  Trial  Balance  to- 
gether with  the  various  schedules,  analyses  and  summaries  sup- 
porting it,  and  prepare  in  journal  form  any  correcting  or  ad- 
justing entries  that  may  be  necessary.  The  reason  for  doing 
this  work  immediately  and  before  leaving  the  place  where  the 
work  has  been  carried  on,  is  that  if  anything  should  develop 
which  requires  attention,  access  to  the  books  is  still  possible. 
It  is  quite  embarrassing  to  discover,  perhaps  several  days  after 
an  audit  has  been  completed,  that  certain  information  is  needed 
and  it  is  impractical  to  return  to  the  office  of  the  client.  Satis- 
factory results  in  such  cases  often  cannot  be  obtained  by  corres- 
pondence. 

Correcting  Entries.  Journal  entries  should  be  made,  to- 
gether with  full  explanations,  for  all  errors,  whether  mechanical 
or  in  principle,  that  have  been  discovered  during  the  course  of 
an  audit.  These  errors  will  be  shown  by  the  working  papers 
prepared  by  the  persons  engaged  on  an  audit.  A  separate 
entry  should  be  made  for  each  error  found.  Usually,  after 
discussing  the  matter  of  errors  with  the  client,  the  bookkeepers 
will  be  instructed  to  make  similar  correcting  entries  on  the 
books  of  account.  If  this  is  done  the  books  will  show  the 
same  results  as  the  statements  prepared  by  the  auditor.  If, 
for  any  reason,  the  books  of  the  client  are  not  corrected,  the 
auditor  should  proceed  with  his  working  papers  in  the  same 
manner  as  outlined,  for  his  statements  must  show  actual, 
financial  conditions. 

Adjusting  Entries.  There  are  certain  facts  which  may 
not  appear  in  the  accounts  at  the  close  of  the  fiscal  period  and 
in  order  that  the  books  may  show  true  conditions  on  that  date 
adjusting  entries  are  required.  Entries  must  be  made  for  ac- 
crued assets,  accrued  liabilities,  deferred  charges  to  operation, 
deferred  credits,  depreciation,  reserves,  inventories,  etc. 

The  Working  Sheet.  It  is  a  comparatively  simple 
matter  to  exhibit  the  results  of  an  audit  in  a  statement,  com- 
monly known  as  a  Working  Sheet.  The  purpose  of  the  Work- 
ing Sheet  is  frequently  misunderstood.  It  is  not  a  statement 
intended  as  a  substitute  for  the  financial  statements,  but  is  a 
summary  of  the  accounts  as  they  appear  in  the  Trial  Balance, 
adjusting  data,  and  a  classification  of  nominal  and  real  accounts, 
and  is  prepared  for  the  purpose  of  gathering  together  all  the 
information  needed  from  which  an  auditor  may  prepare  formal 
financial  statements  and  a  formal  report  for  the  client. 


216  PUBLIC  ACCOUNTING  AND  AUDITING 

The  correcting  and  adjusting  entries  prepared  by  the  audi- 
tor in  connection  with  The  Blank  Manufacturing  Company  ap- 
pear below.  Each  entry  is  followed  by  an  appropriate  explana- 
tion and  needs  no  further  comment,  with  the  possible  exception 
of  the  last  entry  (No.  8)  which  relates  to  the  inventories. 
Some  accountants  do  not  set  up  an  adjusting  entry  for  the 
inventory.  They  simply  enter  the  ending  inventories  in  the 
Working  Sheet  arbitrarily  and  include  them  only  in  the  "closing 
journal  entries".  The  entry  shown  will  be  found  so  simple  and 
easily  understood  that  it  will  be  apparent  at  once  that  it  is 
undoubtedly  the  best  method  for  treating  the  subject. 


THE  BLANK  MANUFACTURING  CO. 

CORRECTING  JOURNAL  ENTRIES 

Dec.  31,  1918 

(1) 
Salaries  of  Salesmen  $30.00 

Salaries  advanced  to  Salesmen  $30.  oo 

To  correct  an  error  of  $30.00  in  the  footing  of 
each  of  above  accounts. 

(2) 
Machinery  $215.00 

Tools  and  Implements  $215.00 

To  correct  an  item  of  $215.00  charged  to  Tools 
and  Implements  which  should  have  been  charged  to 
Machinery  as  it  represented  the  purchase  of  a  new 
machine,  July  I,  1918. 

(3) 
Surplus  $22,500.00 

Dividend  $22,500.00 

To  adjust  account  with  Dividend  authorized, 
July  I,  1918,  but  not  charged  to  Surplus. 


ADJUSTING  JOURNAL  ENTRIES 

Dec.  31,  1918 

(1) 

Factory  Pay  Roll,  Labor  $2,875.00 

Surplus  (Bond  Interest  Accrued)  2,315.07 

Accrued  Liabilities  $5,190.07 

To  set  up  on  the  books  the  Accrued 
Liabilities  as  follows: 

(a)  Factory  pay  roll  accrued  but  not  paid   $2,875.00 

(b)  Accrued    interest    on    first    mortgage 
bonds  $100,000.00  at  5%,  July   15,  1918, 

to  Dec.  31,  1918 $2,315.07 

This  is  charged  to  Surplus  for  the  reason  that 
no  accrued  interest  on  bonds  was  calculated  at  the 
end  of  the  previous  fiscal  period,  hence  the  present 
period  should  only  be  charged  with  bond  interest 
amounting  to  $5,000.00.  The  Surplus  account  must 
be  adjusted  because  of  failure  to  charge  Bond  Interest 
account  for  accrued  interest  at  end  of  the  previous 
period. 


ADJUSTING  ENTRIES 


217 


(2) 
Deferred  Charges  to  Operations  $13,031 .  oo 

Insurance  $      456.00 

Advertising  12,575.00 

To  set  up  Deferred  Charges  to  Oper- 
ations as  follows: 

(a)  Insurance  Unexpired  $456.00 

(b)  Advertising  $25,150.00  to  be  charged 
off   over   period    of   two   years,   one    half 
deferred  $12,575.00 

(3) 
Accrued  Assets  $1,131.17 

I nteiest  and  Discount  $1,131.17 

To  set  up  Accrued  Assets: 

(a)  Interest  accrued  on  investment  of  sur- 
plus $124.59 

(b)  Interest  accrued  on  Sinking  Fund.  875.34 

(c)  Interest  accrued  on  Notes  Receivable  131-24 

(4) 

Depreciation  $11,522.95 

Res.  for  Dep'n.  on  Buildings,  2^%  $3,75O.oo 

Res.  for  Dep'n.  on  Machinery,  6%  6,012.90 

Res.  for  Dep'n.  on  Horses  and  Wagons,  10%  1,500.00 

Office  Furniture  260.05 

To  set  up  proper  amount  of  depreciation  on  fixed 

assets. 

Note — Office    Furniture    is    credited    direct    for 

amount  of  depreciation,  no  reserve  being  set  up. 

(5) 
Organization  Expense  Charged  Off  $735 .00 

Unapportioned  Organization  Expense  $735  oo 

To  charge  off  10%  of  Organization  Expense. 

(6) 
Bond  Discount  Charged  Off  $300.00 

Bond  Discount  Unamortized  $300.00 

To  charge  off  5%  of  Bond  Discount. 

(7) 

Loss  on  Doubtful  Notes  $    258.12 

Loss  on  Bad  Debts  1,694.43 

Reserve  for  Doubtful  Notes  $    258. 12 

Reserve  for  Bad  Debts  1 ,694 . 43 

To  set  up  reserves  for  estimated  loss  of  2%  on 
Notes  and  Accounts  Receivable. 

(8) 

Inventory,  Finished  Stock — new  account.  $80,000.00 

Inventory,    Materials    and    Stock    in    Process — new 

account  59>875.oo 

Inventory,  Finished  Stock — old  account.  $80,000.00 

Inventory,  Raw  Material — old  account.  59.875- oo 

To  set  up  Inventories  as  of  Dec.  31,  1918. 

The  Working  Sheet  on  the  following  pages  shows  the  Trial 
Balance,  the  posting  of  the  preceding  correcting  and  adjusting 
entries,  and  a  proper  classification  of  the  nominal  and  real  ac- 
counts as  prepared  by  E.  R.  Stockman,  senior  accountant,  from 
his  working  papers  and  those  of  the  juniors,  J.  I.  King  and  C. 
E.  Shaw,  his  assistants. 


218 


PUBLIC  ACCOUNTING  AND  AUDITING 


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220  PUBLIC  ACCOUNTING  AND  AUDITING 

A.     THEORY  QUESTIONS 

1.  Would  you  advise  showing  profits  for  prospectus  pur- 
poses before  or  after  deducting  war  profits  and  income  taxes? 
State  your  reasons  briefly.  Inst.  Ex.  1919. 

2.  (a)  What  items  do  you  consider  should  be  charged  or 
credited  direct  to  surplus? 

(b)  Would  you  regularly  make  small    adjustments  of 
subsequently  discovered  errors  through  this  account? 

(c)  Is  the  balance  at  credit  of  surplus  ever  in  any  circum- 
stances a  liability,  and,  if  so,  to  whom?  Inst.  Ex.  1918. 

3.  What  would  you  consider  satisfactory  evidence  of  the 
correctness  and  propriety  of  expenditures  of  the  following  classes : 

Wages  paid, 

Land  purchased, 

Commission  paid  to  bankers  for  sale  of  bonds, 

Salary  of  president, 

Expenses  of  president, 

Pensions  paid  to  ex-employes, 

Directors'  remuneration?  Inst.  Ex.  1918. 

4.  There  is  a  confusion  in  the  minds  of  many  people  between 
statements  of  "revenue  and  expense"  on  the  one  hand  and  of 
"receipts  and  payments"  on  the  other  hand.     Discuss  the    dis- 
tinctive features  of  such  statements  showing  wherein  they  differ. 

Inst.  Ex.  1918. 

B.    ACCOUNTING  PROBLEMS 

I.  Write  a  reply  to  the  following  letter  and  prepare  a 
Balance  Sheet  as  requested  therein : 

Dear  Sir: 

Our  bank  has  asked  us  for  a  statement  for  credit  purposes.  Will  you 
please  prepare  one  for  us? 

Our  plants  stand  at  thsir  cost  price,  which  is  $60,400.  We  have  set  up 
a  reserve  for  a  depreciation  of  $10,200.  There  is  a  mortgage  for  $20,000  on 
the  plant  and  interest  on  the  mortgage  is  at  6  per  cent  and  is  paid  up  to  3 
months  ago.  We  hold  $10,000  of  notes  receivable  and  have  discounted 
$25,000  of  notes  with  the  bank.  Our  accounts  receivable,  which  we  consider 
good,  amount  to  $18,000,  including  $3,000  due  from  one  of  our  employees  on 
personal  account.  Our  trade  accounts  receivable  are  subject  to  5  per  cent 
discount  if  paid  at  due  date,  and  only  $1,000  is  now  past  due.  Our  accounts 
in  suspense  amount  to  $4,000.  I  believe  these  are  50  per  cent  good.  We 
have  ordered  a  new  machine  to  cost  $6,000,  but  it  has  not  yet  been  delivered. 
We  have  endorsed  a  note  for  $6,000  for  our  friends,  the  A.  B.  Co.,  but  I  am 
confident  they  will  take  care  of  it  when  it  is  due.  Our  accounts  payable 
amount  to  $4,200.  Our  insurance  amounts  to  $400  a  year  and  has  six  months 
to  run.  We  have  a  note  at  the  bank  for  $5,000,  interest  paid  to  date.  We 
own  50  shares  of  stock  in  the  company  from  which  we  buy  raw  material. 
They  cost  us  $2,800  and  are  surely  worth  it,  though  we  might  have  some 
difficulty  in  selling  them  in  a  hurry.  Our  inventory  is  taken  at  a  low  selling 
price,  which  is  10  per  cent  more  than  it  cost  us.  The  amount  is  $17,600.  In 
addition  we  have  a  special  contract  for  one  of  our  customers.  The  contract 
price  is  $25,000.  We  have  spent  $12,000  on  it  and  expect  to  have  to  spend 
$4,000  more,  and  we  have  received  $10,000  on  account.  Our  cash  in  bank  is 
$4,800  and  cash  in  hand  $200. 


ACCOUNTING  PROBLEMS  221 

I  have  told  you  all  the  facts  I  think  you  need.  Perhaps  some  are  not 
required,  but  I  want  to  give  the  bankers  all  the  information  they  ought  to 
have  in  the  way  they  expect  to  get  it. 

I  do  not,  of  course,  expect  you  to  accept  any  responsibility  for  the 
figures  in  the  statement,  but  simply  to  prepare  the  statement  in  the  best  form 
you  can  from  this  letter.  If  you  have  any  suggestions  as  to  how  I  can  better 
meet  the  bank's  requirements  let  me  have  them. 

(Signed)         H.  A.  SMITH. 

Inst.  Ex.  1917. 

2.  You  are  asked  to  audit  the  books  of  the  Michigan 
Manufacturing  Company  with  a  view  to  ascertaining  their  true 
financial  position  at  the  close  of  the  year  ending  Dec.  31,  1918. 
The  following  Trial  Balance  is  submitted: 

TRIAL  BALANCE,  DEC.  31,  1918 

Cash  on  Hand  and  in  Bank $        430.15 

Notes  Receivable 7,907.62 

Customers'  Accounts 20,797.80 

Real  Estate  and  Buildings 35.333-83 

Machinery  and  Equipment 12,344.88 

Horses,  Wagons,  etc 1,265.40 

Power  Machinery  Co 727.77 

Manufacturing  Materials 133,848.53 

Misc.  Factory  Supplies 1,631.09 

Productive  Labor 63,842.23 

Freight,  Express  and  Cartage  "In  "  i  ,734.70 

Stable  Expense 1,694.11 

Misc.  Non-Productive  Labor !>993-5O 

Fuel 5.554-82 

Insurance 3,872.32 

Repairs  to  Machinery 507.73 

Water  Tax 140.53 

Advertising 378.58 

Discount  allowed  to  Customers.  .  .  3,362.19 

Postage 264.42 

Salaries 6,170.00 

Stationery  and  Office  Supplies ....  296.02 

Miscellaneous  Main  Office  Expense  241.08 

Interest  Paid 3,386.80 

Accrued  Pay  Rolls $        487.66 

Notes  Payable 22,344.81 

Accounts  Payable 5.512.34 

Sundry  Creditors 2,511.89 

Reserve  for  Bad  Debts 1,059.51 

Capital  Stock 85,000.00 

Sales 187,540.38 

Discounts  Earned  on  Purchases. . .  2,081.59 

Interest  Earned 463.17 

Miscellaneous  Earnings 724.75 

$307,726.10  $307,726.10 


222  PUBLIC  ACCOUNTING  AND  AUDITING 

During  the  course  of  your  audit  you  find  that  the 
inventory  of  manufacturing  material  at  the  beginning  of 
the  year  was  $27,214.41,  and  at  the  close  of  the  year 
$51,358.58.  At  the  close  of  the  year  there  was  also  factory 
supplies  on  hand  to  the  amount  of  $200.00,  as  well  as  fuel 
$2,188.40,  and  horse  feed  $14.22.  You  find  that  the  unexpired 
insurance  premiums  amounted  to  $1,720.18;  that  the  accrued 
interest  on  notes  payable  amounted  to  $134.83  and  accrued 
taxes  to  $376.75.  An  analysis  of  the  customers'  accounts  dis- 
closed the  fact  that  $9,128.11  was  very  doubtful  of  collection. 
The  item  of  $727.77  to  Power  Machinery  Co.  represents  an 
advance  payment  made  on  machinery  which  has  been  purchased, 
but  not  yet  completely  installed  antl  not  included  in  Machinery 
account.  You  find  in  the  account  for  Horses  and  Wagons  a 
charge  for  $75.00  for  difference  paid  on  an  exchange  of  horses, 
the  new  horse  being  presumably  of  the  same  value  at  which  the 
old  horse  originally  entered.  Prepare  Balance  Sheet,  Manufac- 
turing Statement  and  Profit  and  Loss  statement  providing  for 
depreciation  of  10%  on  Machinery  and  Equipment. 

C.  P.  A.  Mich. 

(Note.  You  are  also  required  to  prepare  the  adjusting  journal  entries 
and  a  Working  Sheet  similar  in  form  to  the  one  illustrated  on  pages  220  and 
221  of  this  chapter.  It  is  important  that  your  entire  solution  be  prepared  in 
standard  form,  neatly  exhibited  and  absolutely  accurate.  After  you  have 
your  working  papers  ready  to  submit,  be  sure  to  check  each  item  over  again, 
using  every  precaution  to  avoid  any  possible  errors  or  misstatements.  Let  your 
statements  be  in  such  form  as  you  would  prepare  them  if  they  were  to  be 
submitted  to  a  client.) 

PRACTICE  DATA 

(Continued  from  Chapter  Thirteen) 

Transaction  No.  6.  Upon  demand,  the  following  sub- 
scribers to  the  capital  stock  paid  their  subscriptions  in  full  in 
cash  arid  stock  certificates  were  issued: 

A.  B.  Opfer $300,000.00 

H.  W.  Henry 100,000.00 

Maude  E.  Barnes : 300,000.00 

Ruth  E.  Forry 350,000.00 

E.  W.  Atkinson 550,000.00 

Transaction  No.  7.  The  following  purchases  for  cash 
were  made: 

Machinery $300,000.00 

Land 500,000.00 

Buildings 250,000.00 

Merchandise 500,000.00 

Transaction  No.  8.  All  of  the  preceding  transactions 
really  relate  to  the  organization  of  the  company  and  were  com- 
pleted before  the  company  was  ready  to  begin  operations.  Open 
accounts  on  ledger  paper,  allowing  eight  lines  for  each  account 
and  post  your  journal  entries.  Take  a  Trial  Balance  as  of  Dec- 
ember 31,  1919. 


ACCOUNTING  PROBLEMS  223 

Transaction  No.  9.  At  the  close  of  business  December  31, 
1920,  it  was  decided  to  employ  a  Certified  Public  Accountant 
to  make  an  audit  of  the  books  of  the  company.  Assume  that 
you  were  directed  to  complete  the  audit  and  prepare  the  report. 
The  business  has  been  in  operation  for  a  period  of  one  year. 
Preliminary  investigation  showed  that  the  system  of  accounts 
had  been  poorly  devised  and  that  no  satisfactory  internal  check 
had  been  maintained;  therefore,  a  detailed  audit  was  recom- 
mended and  authorized.  During  the  course  of  the  audit  it 
became  evident  that  the  book  entries  could  not  be  relied  on 
and  many  vouchers  were  missing.  There  seemed  to  be  no  evi- 
dence of  embezzlement,  but  the  errors  seemed  to  be  due  to  a 
lack  of  knowledge  of  the  ordinary  principles  of  bookkeeping 
on  the  part  of  the  bookkeeper.  It  seemed  no  effort  had  been 
made  to  keep  the  books  in  balance,  the  bookkeeper  apparently 
having  been  satisfied  in  keeping  only  his  cash  in  balance.  Aggre- 
gate entries  were  found  to  have  affected  the  respective  accounts 
during  the  current  year  as  follows: 

Purchases $306,000.00 

Pay  Rolls 212,000.00 

Factory  Expenses 18,000.00 

Freight  and  Express  (Inbound) 1,000.00 

Administrative  Expenses 27,000.00 

Selling  Expenses 8,000.00 

Interest  on  Notes  Payable 22,000.00 

Miscellaneous  Interest  Expense 500.00 

Interest  Received 1,000.00 

Sales 942,000.00 

Returns  and  Allowances  (Sales) 4,000.00 

Bad  Debts  and  Special  Allowances 32,000.00 

Freight  on  Goods  Sold 2,000.00 

Machinery,  Tools  and  Equipment(Add.). .  .  37, 530.00 

Office  Furniture  and  Fixtures  (Additions). .  800.00 

Machinery,  Tools  and  Equipment  Sold 19,000.00 

Patents  (Additions) 10,000.00 

Analysis  of  the  Machinery  account  showed  that  the  cost 
price  of  the  machinery,  tools  and  equipment  sold  was  $20,000.00, 
there  having  been  a  loss  of  $1,000.00  incurred  through  the  sale. 
Post  above  aggregate  entries  to  the  proper  accounts,  opening 
new  accounts  when  necessary.  Journal  entries  are  not  required. 

Transaction  No.  10.  After  analyzing  the  ledger  accounts, 
the  following  net  changes  were  found  to  have  occurred  in  the 
respective  accounts  during  the  course  of  the  year: 


224  PUBLIC  ACCOUNTING  AND  AUDITING 

Debit        Credit 
Cash  ..............................  $134,870.00 

Notes  Receivable  ....................       7,000.00 

Accounts  Receivable  .................     35,000.60 

Prepaid  Administrative  Expenses  ......        1,000.00 

Notes  Payable,  Banks  .............  $7,700.00 

Notes  Payable,  Trade  ................     57,000.00 

Accounts  Payable  ...................     67,000.00 

Accrued  Pay  Roll  ...................  8,000.00 

Notes  Receivable  Discounted  .........  5,000.00 

Accrued  Salaries  is  the  same  as  at  the  end  of  the  previous 
year.  Post  to  the  proper  accounts.  Journal  entries  are  not 
required. 

Transaction  No.  11.  It  was  found  that  the  entire  inter- 
est on  the  First  and  Second  Mortgage  Bonds,  amounting  to 
$29,880.00,  has  been  added  to  machinery  and  tools.  The  interest 
on  the  Debenture  Bonds,  amounting  to  $7,650.00,  had  been 
charged  to  administrative  expense.  All  bonds  were  issued 
December  31,  1919,  the  interest  payable  semiannually  on  June 
30  and  December  31. 

Formulate  correcting  entries  in  journal  form  and  post  to 
the  proper  accounts.  Take  a  Trial  Balance. 

Transaction  No.  12.     Specific  reserves  are  to  be  set  up 

as  follows: 


Reserve  for  depreciation  on  buildings  ........... 

Reserve   for  depreciation   on   machinery,    tools 

and  equipment  ..........................      10% 

Depreciation  on  patents  ......................       6% 

Depreciation  on  office  furniture  and  fixtures  .....      10% 

Reserve  for  doubtful  accounts  ................. 


Depreciation  is  to  be  calculated  on  the  cost  price  of  fixed 
assets  on  hand  at  the  beginning  of  the  current  year.  The  reserve 
for  doubtful  accounts  is  estimated  to  amount  to  2^%  of  the 
total  accounts  receivable  as  at  the  end  of  the  current  year. 
(Drop  the  cents.  Use  the  nearest  dollar.) 

The  inventory  shows  merchandise  on  hand  amounting  to 
$650,000.00. 

Formulate  adjusting  journal  entries. 


Chapter  Fifteen 


THE  REPORT 

In  the  previous  chapter  there  was  illustrated  the  Working 
Sheet  prepared  by  the  senior  in  charge  of  the  audit  of  The  Blank 
Manufacturing  Company. 

After  the  senior  in  charge  has  prepared  a  Working  Sheet, 
supported  by  the  necessary  schedules  from  the  working  papers 
of  the  various  persons  employed  in  connection  with  an  audit, 
and  has  them  arranged  in  proper  form,  they  are  usually  turned 
over  to  someone  in  the  office,  whose  duty  it  is  to  prepare  what 
is  known  as  a  Report.  This  Report  may  be  divided  into  three 
parts — the  statements,  the  comments  and  the  certificate. 

The  Statements.  There  are  two  classes  of  statements — 
exhibits  and  schedules.  The  principal  statements,  such  as  the 
Balance  Sheet  and  the  Profit  and  Loss  statement  are  known  as 
exhibits,  while  the  supporting  statements,  such  as  a  Statement 
of  Factory  Operations,  Analysis  of  General  Expenses,  Statement 
of  Investments,  etc.,  are  known  as  schedules. 

It  is  needless  to  say  that  every  possible  precaution  must  be 
used  to  insure  absolute  accuracy  in  the  preparation  of  the  state- 
ments. All  the  information  should  be  obtainable  from  the 
Working  Sheet  and  working  papers  which  accompany  it.  The 
calculations  and  copying  must  be  carefully  verified  by  someone 
in  authority.  It  is  customary  for  the  managing  senior,  a  partner 
of  the  firm,  or  an  officer  of  the  company  to  pass  upon  the  entire 
report  before  submitting  it  to  the  client. 

In  preparing  the  report,  the  auditor  should  have  in  mind 
the  use  that  will  be  made  of  the  information  it  will  contain,  for 
he  may  occasionally  be  able  to  make  his  report  cover  more  fully 
some  special  points  that  will  be  of  particular  interest  to  the  client. 
For  instance,  the  prospective  purchaser  of  stock  would  be  pri- 
marily interested  in  the  earnings  or  dividends  of  the  corporation 
and  of  its  value  as  a  going  concern.  The  prospective  purchaser 
of  bonds  would  be  principally  interested  in  the  value  of  the  pro- 
perty mortgaged  and  the  ability  of  the  company  to  maintain  the 
interest  payable  during  the  life  of  the  bonds  and  to  retire  them 
at  maturity.  The  banker,  while  interested  incidentally  in  the 
earning  capacity  of  the  concern,  would  be  primarily  desirous  of 
knowing  the  probable  ability  of  the  concern  to  repay  the  loan  at 
maturity.  The  stockholder's  chief  interest  is  usually  in  the  earn- 

225 


226  PUBLIC  ACCOUNTING  AND  AUDITING 

ing  capacity  of  the  corporation  and  of  the  conduct  of  the  business 
in  the  past  by  the  directorate  chosen  by  the  stockholders. 

The  Comments.  It  is  customary  for  the  auditor  to  sub- 
mit comments  in  connection  with  the  statements  prepared  for 
the  client.  These  comments  are  made  to  explain  any  unusual 
items  appearing  in  the  financial  statement,  to  describe  his  investi- 
gations into  certain  matters,  to  present  what  criticisms  are  con- 
sidered necessary,  to  make  suggestions  that  may  be  of  value  to 
the  client,  and,  if  so  requested,  to  make  what  recommendations 
he  considers  advisable. 

Properly  prepared  comments  may  be  of  great  value  to  a 
client.  They  may  be  constructive  and  may  lead  to  vast  improve- 
ments in  the  accounting  records  and  the  means  of  keeping  the 
records.  If  a  proper  method  of  internal  check  has  not  been 
maintained,  he  may  make  suggestions  as  to  how  to  bring  about 
a  satisfactory  system  of  internal  checking.  This  is  undoubtedly 
constructive.  Wildman  says,  concerning  the  wording  of  the 
report  that,  "Good  construction  advocates  the  use  of  simple 
words,  short  sentences  and  nontechnical  expressions  as  far  as 
possible.  By  so  doing  someone  may  be  bored,  but  it  is  much 
better  to  use  language  which  the  ordinary  man  understands 
rather  than  to  attempt  to  impress  readers  with  literary  style. 
It  is  not  necessary  to  indulge  in  literary  style.  All  that  is  re- 
quired is  to  express  such  thoughts  as  a  person  may  have  in  con- 
nection with  a  technical  subject  in  a  clear,  concise  way  which 
the  layman  will  understand.  The  professional  auditor  is  not 
expected  to  be  a  literary  expert.  He  is  expected  to  have  an  ac- 
counting sense  and  to  understand  accounting,  and  to  be  able  to 
use  English  sufficiently  well  to  express  clearly  what  he  has  to  say 
on  the  subject." 

The  Certificate.  When  an  auditor  is  employed  by  a  busi- 
ness man,  he  is  expected  to  submit  proper  statements  of  financial 
condition  in  standard  form  properly  certified.  The  object  of  ob- 
taining a  certificate  from  the  auditor  is  to  secure  from  an  unbias- 
ed person,  one  who  is  skilled  in  professional  accounting,  an 
opinion  as  to  the  accuracy  of  the  accounts  and  statements  which 
exhibit  actual  financial  conditions. 

Federal    Reserve   requirements   specify   that, 

"The  Balance  Sheet  and  certificate  should  be  connected 
with  the  accounts  in  such  a  way  as  to  ensure  that  they  shall  be 
used  only  conjointly.  This  rule  applies  also  to  any  report  or 
memorandum  containing  any  reservations  as  to  the  auditor's 
responsibility;  any  qualification  as  to  the  accounts,  or  any  refer- 
ence to  facts  materially  affecting  the  financial  position  of  the 
concern. 

"The  certificate  should  be  as  short  and  concise  as  possible, 
consistent  with  a  correct  statement  of  the  facts,  and  if  qualifi- 
cations are  necessary  the  auditor  must  state  them  in  a  clear  and 
concise  manner. 


THE  REPORT  227 

"If  the  auditor  is  satisfied  that  his  audit  has  been  complete 
and  conforms  to  the  general  instructions  of  the  Federal  Reserve 
Board,  and  that  the  Balance  Sheet  and  Profit  and  Loss  state- 
ment are  correct,  or  that  any  minor  qualifications  are  fully  cov- 
ered by  the  footnotes  on  the  Balance  Sheet,  the  following  form 
is  proper: 


"I  have  audited  the  accounts  of  Blank  &  Co.  for  the 

period  from to and  I  certify 

that  the  above  Balance  Sheet  and  statement  of  Profit  and 
Loss  have  been  made  in  accordance  with  the  plan  sug- 
gested and  advised  by  the  Federal  Reserve  Board,  and  in 
my  opinion  set  forth  the  financial  condition  of  the  firm  at 

and  the  results  of  its  operations  for  the 

period. 

(Signed), 

A.  B.  C." 


The  Auditor's  Responsibility.  Opinions  vary  as  to  the 
extent  of  an  auditor's  guarantee,  and  as  to  his  legal  responsi- 
bility in  case  of  an  error  being  subsequently  discovered  in  the 
statements  which  he  has  certified.  This  responsibility  was  dis- 
cussed briefly  on  page  9  of  Chapter  One.  Concerning  the  extent 
of  an  auditor's  guarantee,  what  Lawrence  R.  Dicksee,  F.  C.  A., 
of  the  firm  of  Price  &  Dicksee,  says  in  his  manual  on  "Auditing" 
is  so  appropriate  that  we  can  do  no  better  than  to  quote  from 
him: 

"Unfortunately,  this  is  a  matter  upon  which  the  profession 
are  by  no  means  agreed;  while,  on  the  other  hand,  the  cases  that 
have  been  decided  by  the  courts  are  so  few,  and  the  questions 
at  issue  actually  so  narrow,  that  sufficient  precedents  are  not 
available  to  definitely  settle  the  matter.  At  the  same  time,  it  is 
well  to  remember  that,  however  desirable  it  may  be  to  know  ex- 
actly the  bare  extent  of  the  legal  responsibility,  the  real  profes- 
sional responsibility  to  clients  ought  always  to  be  the  ideal,  and, 
further,  an  auditor  will  be  the  worst  of  friends  to  his  profession 
if  he  studiously  exerts  himself  to  narrow  the  responsibilities, 
and  so  to  dwarf  the  importance  of  his  position. 

"The  responsibility  involved  in  certifying  a  Balance  Sheet 
to  be  absolutely  correct  is  so  great,  so  limitless,  that  many  have 
preferred  to  discard  all  claim  to  such  a  position  of  certainty,  and 
prefer  merely  to  certify  a  Balance  Sheet  as  being  'in  accordance 
with  the  books.'  Auditors,  however,  will  hardly  require  to  be 
reminded  that  an  investigation  which  had  been  limited  to  the 


228  PUBLIC  ACCOUNTING  AND  AUDITING 

comparison  of  the  Balance  Sheet  with  the  books  would  be,  for 
every  purpose,  absolutely  valueless.  So  obvious  is  this  conclu- 
sion that  no  professional  auditor  would  ever  think  of  confining 
his  investigation  to  this  particular  point,  yet  many  experienced 
auditors  appear  to  be  afraid  to  make  any  certification  as  to  the 
result  of  such  further  investigation  as  they  know  to  be  essential. 
Such  a  state  of  affairs  is  unsatisfactory  to  the  client  and  dis- 
creditable to  the  auditor.  Again,  it  is  a  very  open  question  as  to 
whether  so  unsatisfactory  a  certificate  would  ever  have  the  effect 
of  limiting  the  legal  responsibility  of  the  auditor  to  the  exact 
points  certified.  It  is,  at  least,  possible  that  the  court  would  view 
the  matter  from  a  broader  aspect,  and  consider  that  the  man  who 
had  accepted  the  position  of  auditor,  to  say  nothing  of  the  fees 
incident  thereto,  had  also  undertaken  the  responsibilities  of  that 
position,  and  that  it  would  be  disposed  to  form  its  own  opinion 
as  to  the  real  extent  of  such  responsibilities. 

"It  would  appear,  therefore,  that  the  auditor  who  does  not 
consider  his  investigation  has  been  sufficiently  searching  escapes 
no  liability  by  issuing  a  carefully  modified  certificate;  and,  indeed, 
such  a  course  is  decidedly  unmanly,  somewhat  dishonest  and  ex- 
ceedingly childish.  These  are  strong  words,  but  not  stronger 
thq.n  the  circumstances  appear  to  require. 

"When  addressing  a  meeting  of  the  Institute  of  Chartered 
Accountants,  Mr.  Frederick  Whinney,  F.  C.  A.,  expressed  himself 
as  follows:  'I  know  perfectly  well  that  a  proper  auditor  must  go 
further  (than  comparing  the  published  accounts  with  the  books) 
and  see  that  books  themselves  do  correspond,'  and  this  view  ap- 
pears to  be  endorsed  by  legal  decisions.  As  to  how  far  it  is  pos- 
sible for  this  standard  to  be  carried  into  practice,  there  is  perhaps 
some  room  for  the  elasticity  of  individual  opinion,  but  the  general 
statement  is  absolutely  unassailable. 

"The  chief  evidence  is,  of  course,  the  books  (and  it  may  be 
remarked,  incidently,  that  it  is  clearly  the  auditor's  duty  to  see 
that  the  accounts  he  certified,  in  addition  to  being  correct,  are  in 
accordance  with  the  books) ,  but  the  books  must  not  be  considered 
the  sole  source  of  evidence;  the  fact  that  a  statement  appears  in 
the  books  is  prima  facie  evidence  only,  and  must  be  verified,  not 
only  by  internal  cross-examination,  but  also  by  reliable  and  in- 
dependent evidence. 

"The  result  of  such  an  examination  will  be  that  the  auditor 
has  proved  to  himself  that  certain  statements  represent  absolutely 
indisputable  facts,  and  that  certain  other  statements  in  his  opin- 
ion appear  to  represent  facts.  Beyond  this — not  being  omnis- 
cient— he  can  not  go,  and  should  never  attempt  to  go.  Let  him 
therefore  certify  that  he  has  thoroughly  examined  the  accounts, 
that  they  are  in  accordance  with  the  books,  and  are,  in  his  opin- 
ion, correctly  stated;  he  will  then  be  occupying  a  logical,  manly 
position — far  more  in  keeping  with  the  dignity  of  his  profession 
than  that  afforded  by  the  most  skillful  of  word  juggling." 


THE  REPORT  229 


OFFICE:  *fi      ffi      Q'  |  x          Telephone  Main  2647 

309  W.  TH.RD  ST.  A.   J  .   ^KWWKWb 

CINCINNATI,  0.  AUDITS 

CERTIFIED  PUBLIC  ACCOUNTANT  REPORTS 

AND  AUDITOR 


Cincinnati,  Ohio,     March  i,  1919. 

THE  BLANK  MANUFACTURING  CO. 

CERTIFICATE 


Mr.  C.  H.  Becker, 

Chairman,  Board  of  Directors, 
The  Blank  Manufacturing  Co., 
Indianapolis,  Ind. 

Dear  Sir: 

In  accordance  with  our  engagement,  I  have  made  an  audit  of  the 
accounts  of  The  Blank  Manufacturing  Company  for  the  year  ended 
December  31,  1918,  and  herewith  submit  my  report  which  includes 
the  following: 

Exhibit     "A"    — Balance  Sheet,  December  31,  1918. 

Exhibit  "B"  — Statement  of  Profit  and  Loss  for  the  year 
ended,  December  31,  1918. 

Schedule  "B-l" — Statement  of  Cost  of  Goods  Manufactured 
and  Sold  for  the  year  ended,  December 
31,  1918. 

Comments.  (Two  pages.) 

I  HEREBY  CERTIFY  that  the  attached  statements  have  been 
prepared  in  accordance  with  the  plans  suggested  and  advised  by  the 
Federal  Reserve  Board  and,  in  my  opinion,  set  forth  the  true  financial 
condition  of  the  business  as  of  December  31,  1918,  and  the  results  of 
operations  for  the  year  ended  December  31,  1918. 

Respectfully  submitted, 

(Signed)    J.  F.  SHERWOOD 
C.  P.  A. 


230 


PUBLIC  ACCOUNTING  AND  AUDITING 


THE  BLANK  MANUFACTURING  GO. 


Balance  Sheet— Dec.  31, 1918 

ASSETS 
Cash: 

Cash  in  Bank 

Cash    Dep.    for    Div.  No.  9      $2,050.00 
Less  Div.  Vouchers  Out.        2,050.00 
Cash  Dep.  for  Bond  Int — 
Notes  and  Accounts  Receivable: 

Notes  Rec.  Cus.  (Not  past  due)  10,806.00 

Accts.  Rec.  Cus.  (Not  past  due)  73,807.80 

Notes  Rec.  Customers  (Past 
due  but  considered  good).. 
Accts.  Rec.  Cus.  (Past  due). 


$20,162.00 


2,500.00    $22,662.00 


600.00 
10,913.70 
96,127.50 


Less: 

Res.  for  Dht.  Notes,  2%  258.12 

Res.  for    Bad   Debts,  2%        1,750.43        2,008.55      94,118.95 
Inventories,  Dec.  31,  1918: 

Mat.  and  Work  in  Process. .  59, 875.00 

Finished  Stock 80,000.00     139,875.00 

Accrued  Assets: 

Interest  on  Notes  Receivable  13 1.24 

Interest    on  Inv.  of  Surplus  ^4.59 

Interest  on  Sinking  Fund. .  . .  875.34        1,131.17 

Total  Quick  Assets ~  $257,787.12 

Securities: 

Notes  Receivable  (Gen.  Mgr.)  1,500.00 

Investment  of  Surplus 10,000.00 

Salaries  Adv.  to  Salesmen..  950.00      12,450.00 

TotalCurrent  Assets $270,237. 12 

Fixed  Assets: 

Land 100,000.00 

Buildings 150,000.00 

Less  Res.  for  Depr.  2^%        6,250.00     143,750.00 
Machinery 100,215.00 

Less  Res.  for  Depr.  6%.  . .       15,012.90      85,202.10 

Tools  and  Implements 20.000.00 

Horses,  Wagons  and  Harness       15,000.00 

Less  Res.  for  Depr.  10%. .         3.000.00       12,000.00 
Office  Furniture 2,600.50 

Less  Depreciation 260.05        2,340.45 

363,292.55 
Sinking  Fund 15,000.00 

Total  Fixed  Assets $378,292.55 

Deferred  Charges  to  Operations: 

Insurance 456.00 

Advertising 12,575.00 

Unapportioned  Organ.  Exp.  6,615  oo 

Bond  Discount  Unamortized  5,700.00      25,346.00 

Total  Assets ~~  $673.875 .67 

Exhibit  "A" 


THE  REPORT 


231 


THE  BLANK  MANUFACTURING  CO. 
Balance  Sheet— Dec.  31, 1918 

LIABILITIES 


Notes  and  Accounts  Payable: 

Notes  Payable , $21,000.00 

Accounts  Payable 51,780.50    $72,780.50 

Special  Accounts  Payable: 

Due  to  Officers  and  Clerks 7,681.50 

Customers  with  Credit  Balances 3*034.50      1.0,716.00 

Accrued  Liabilities: 

Factory  Pay  Roll — Labor 2,875.00 

Bond  Interest  Accrued 2,315.07        5,190.07 

Total  Current  Liabilities "  "$88,686.57 

Fixed  Liabilities: 

First  Mortgage  5%,  2O-year  Bonds 100,000.00 

Reserve  Accounts: 

Sinking  Fund  Reserve 15,000.00 

Reserve  for  Bond  Interest 2,500.00       17,500.00 

~  $206,186.57 

Net  Worth: 

Capital  Stock  Authorized . , 500,000.00 

Less  Unsubscribed  Stock 50,000.00 

450,000.00 

Surplus 13,719.93 

Undivided  Profits  (see  Exhibit  "B") 78,969.17 

542,689.10 

Less  Book  Value  of  Good  Will 75,000.00  $467,689.10 


Total  Liabilities  and  Net  Worth 

Exhibit  "A" 


$673,875-67 


232 


PUBLIC  ACCOUNTING  AND  AUDITING 


THE  BLANK  MANUFACTURING  CO. 

Statement  of  Profit  and  Loss 

Year  Ended  Dec.  31,  1918 

Sales  (less  returns  and  allowances)  $625,275.00 

Less  Cost  of  Sales  (Schedule  "B-i")  439.42940 

Gross  Profit  on  Sales $185,845.60 

Operating  Expenses: 
Selling  Expenses: 

Advertising $12,575.00 

Salaries  of  Salesmen 30,250.00 

Stable  Expense 2,000.00 

Depr.     on    Horses,    Wagons 

and  Harness 1,500.00 

Total  Selling  Expenses 46,325.00 

General  Expenses: 

Office  and  Other  Expenses . .       12,875.00 
Office  Salaries  and  Clerical 

Force 37,560.00 

Depr.  on  Office  Furniture..  260.05 

Loss  on  Doubtful  Notes,  2%  258.12 

Loss  on  Bad  Debts,  2% 1,694.43 

Total  General  Expenses 52,647.60 

Total  Expenses 98,972.60 

Net  Profit  on  Sales $86,873.00 

Other  Income:  .... 

Rent  from  Part  of  Business 

Premises 250  oo 

Gross  Income §87,123.00 

Deductions  from  Income: 

Interest  and  Discount 2,118.83 

Bond  Interest 5,000.00 

Total  Deductions 7,118.83 

Net  Operating  Income $80,004.17 

Special  Charges  to  Profit  and  Loss: 
Organization  Expense  Writ- 
ten off 735-OO 

Bond  Discount  Amortized. . .  300.00 

Total  Special  Deductions. . . .  1,035.00 

Profit  for  Period  (To  Surplus) .  $78,969.17 

Surplus,  Jan.  I,  1918 38,535-QO 

Less: 

Dividend,  July  I,  1918 22,500.00 

Bond  Interest  Adjustment ..         2,315.07      24,815.07        13,719-93 
Surplus,  Dec.  31,  1918 $92,689.10 


Exhibit  "B" 


THE  REPORT 


233 


THE  BLANK  MANUFACTURING  CO. 

Statement  of  Cost  of  Goods  Manufactured  and  Sold 
Year  Ended  Dec.  31,  1918 


Material: 

Inventory,  Raw  Material,  12-31-17 $37,310.50 

Purchases 195,000.00 

In-freight  and  Cartage 2,831.00 

Cost  of  Material  Consumed 235,141.50 

Labor,  Factory  Pay  Roll 303,075.00 

Prime  Cost  of  Material  Consumed $538,216.50 

Manufacturing  Expenses: 

Maintenance  and  Repairs 13,471.00 

Depreciation — 

Machinery,  6% 6,012.90 

Buildings,  2^>% 3.75O.OO 

Taxes 2,010.00 

Insurance 844.00 

Total  Manufacturing  Expenses 26,087.90 

$564,304.40 

Deduct: 

Inventory,  Materials  and  Stock  in  Process 

12-31-18 59,875.00 

Cost  of  Production $504,429.40 

Add: 

Inventory,  Finished  Stock,  12-31-17 15,000.00 

$519,429.40 

Deduct: 

Inventory,  Finished  Stock,  12-31-18 80,000.00 

Cost  of  Sales  (To  Exhibit  "B") $439,429.40 


Schedule  "B-l" 


234  PUBLIC  ACCOUNTING  AND  AUDITING 

THE  BLANK  MANUFACTURING  CO. 

Comments  on  the  Audit 
For  the  Year  Ended  Dec.  31,  1918 

1.     ACCOUNTS  RECEIVABLE 

The  individual  accounts  receivable  were  verified  by  correspon- 
dence. The  schedule  of  the  accounts  from  the  customers  ledger  was 
checked  and  it  agreed  with  the  controlling  account  in  the  general 
ledger.  A  fact  to  be  noted,  however,  is  that  the  total  debit  balances 
of  customers'  accounts  amounted  to  $84,721.50,  while  there  were 
credit  balances  amounting  to  $3,034.50.  Instead  of  using  the  balance 
of  the  controlling  account  in  the  Balance  Sheet,  it  was  thought  best 
to  list  the  total  debit  balances  among  the  current  assets  and  to  list 
the  total  credit  balances  among  the  current  liabilities. 

2.  INVENTORIES 

The  inventories  were  carefully  checked  and  tested  and  found 
to  be  correct  as  stated.  They  were  calculated  at  cost  or  market  price, 
whichever  was  the  lower.  It  would  have  been  better  had  the  inventory 
of  "raw  material"  and  "work  in  process"  been  separated,  but  for 
some  unexplainable  reason  they  were  combined  in  one  sum.  This 
has  no  material  effect  upon  the  statements  at  this  time.  Hereafter, 
it  would  be  better  to  state  the  inventory  in  three  divisions: 

(a)  Raw  Material. 

(b)  Work  in  Process. 

(c)  Finished  Goods. 

3.  FIXED  ASSETS 

All  fixed  assets  are  stated  at  cost  less  the  depreciation  provided 
for.  Reserves  for  depreciation  have  been  established  for  all  of  the 
fixed  assets,  except  tools  and  implements,  and  office  furniture,  the 
practice  having  been  to  credit  the  Office  Furniture  account  direct 
with  the  amount  of  depreciation,  and  to  take  a  physical  inventory 
of  tools  and  implements  annually. 

4.     RATES  OF  DEPRECIATION 

The  rates  of  depreciation  are  considered  approximately  correct 
as  stated.  _  It  is  to  be  noted,  however,  that  in  the  case  of  machinery, 
no  provision  has  been  made  for  obsolescence.  Inasmuch  as  there 
is  a  likelihood  of  obsolescence  with  regard  to  the  machines  in  use 
before  they  have  depreciated  to  scrap  value,  it  might  be  well  to  take 
cognizance  of  it.  The  rate  of  depreciation  is  not  sufficiently  high 
to  provide  for  this  obsolescence. 

5.     AMORTIZATION  OF  BOND  DISCOUNTS 

The  method  of  amortizing  the  bond  discounts  which  were  set  up  at 
the  time  of  the  sale  of  the  bonds  is  not  scientifically  correct  but  is 
reasonably  accurate,  and  it  is  doubtful  whether  there  would  be  any 
real  value  in  changing  the  established  procedure  at  this  time. 

6.     BOND  INTEREST 

At  the  end  of  the  previous  period,  December  31,  1917,  there 
should  have  been  charged  to  Bond  Interest  the  amount  of  the  accrued 
interest  from  July  15  to  December  31,  1917.  This  was  not  done, 
hence  it  was  necessary  to  adjust  the  Surplus  account  because  we  could 
not  charge  more  than  $5,000.00  to  the  Bond  Interest  account  for  the 
year  1918,  as  the  total  interest  on  the  bonds  for  the  year  would  only 
amount  to  this  sum. 


THE  REPORT  235 


7.     INCOME  AND  EXCESS  PROFIT  TAXES 

It  would  be  unwise  to  distribute  the  net  profit  for  the  year  be- 
fore provision  has  been  made  for  Income  and  Excess-Profits  Taxes. 
At  least,  a  reserve  for  the  estimated  amount  of  such  taxes  should 
be  set  up  before  any  action  is  taken  regarding  the  distribution  of  profits. 

8.     SINKING  FUND  APPROPRIATION 

There  is  a  provision  to  the  effect  that  $15.000.00  must  be  appor- 
priated  for  the  sinking  fund  before  profits  are  distributed. 
9.     ADVERTISING 

This  account  represents  expenditures  in  connection  with  the  pub- 
lication of  a  catalog  and  miscellaneous  advertising  matter,  and,  inas- 
much as  a  physical  inventory  shows  that  a  large  part  of  this  material  is 
still  on  hand  and  unused,  it  was  thought  best  to  defer  one-half  of  the 
cost  to  the  next  fiscal  period.  This  advertising  matter  is  to  be  used 
over  a  period  of  two  years,  and,  inasmuch  as  both  years  will  benefit 
from  it  equally,  we  have  only  charged  off  one-half  of  the  cost  of  adver- 
tising to  current  expenses. 

10.     ORGANIZATION  EXPENSES 

Investigation  showed  that  there  were  organization  expenses 
amounting  to  $7,350.00  that  had  not  been  charged  off.  The  policy  of 
the  company  has  been  to  charge  off  10  percent  of  the  balance  of  this 
account  annually.  While  it  might  be  more  conservative  to  charge  this 
off  over  a  shorter  period  of  time,  yet  in  the  face  of  the  fact  that  there  is 
no  doubt  but  that  the  first  ten  years  will  benefit  from  these  expendi- 
tures, there  can  be  no  harm  in  apportioning  them  over  this  period  of 
time. 

11.     GOOD  WILL 

At  the  time  the  corporation  was  formed  the  business  of  a  partner- 
ship was  in  part  taken  over.  The  corporation  was  forced  to  pay  a  sum 
of  $75,000.00  on  account  of  the  good  will  of  the  partners.  This  valua- 
tion was  based  largely  upon  the  value  of  a  trade  name  and  other  in- 
tangible assets.  Inasmuch  as  the  account,  therefore,  represents  an 
actual  investment,  it  would  seem  that  there  can  be  no  criticism  in  per- 
mitting it  to  stand  on  the  books  of  account.  While  it  might  be  con- 
servative practice  to  write  off  the  account  proportionately  over  a  period 
of  years,  yet  this  is  a  financial  matter  to  be  decided  by  the  management. 
It  is  to  be  noted  that  instead  of  classifying  it  among  the  assets  in  the 
Balance  Sheet,  we  have  deducted  it  from  the  net  worth  of  the  concern. 

Since  we  have  been  asked  to  express  our  opinion  in  the  matter,  we 
believe  that  it  would  be  wise  to  install  a  Cost  Accounting  system  which 
should  connect  with  the  general  accounting  records,  and  would  enable 
the  management  to  determine  costs  accurately  and  thereby  determine 
selling  prices  in  an  intelligent  manner  instead  of  a  more  or  less  arbitrary 
manner  as  at  present.  The  material  and  stock  records,  if  kept  prop- 
erly, would  also  enable  the  chief  accountant  to  furnish  monthly  com- 
parative statistics  and  interim  financial  statements  that  would  prove 
of  great  benefit  to  the  executives  in  making  their  plans,  and  would 
enable  them  to  know  just  where  they  stand  at  all  times. 

In  conclusion,  we  are  desirous  of  expressing  our  appreciation  of  the 
cooperation  rendered  us  during  the  period  of  the  audit,  and  we  also 
desire  to  state  that  the  books  of  account  have  been  kept  accurately  and 
neatly,  which,  of  course,  aided  materially  in  completing  the  audit 
promptly. 

Respectfully, 
(Signed)  J.  F.  SHERWOOD, 

C.  P.  A. 


236 


PUBLIC  ACCOUNTING  AND  AUDITING 


A.    THEORY  QUESTIONS 

1.  What  is  meant  by  a  qualified   certificate?     Give  an 
illustration  of  a  case  in  which  a  qualified  certificate  might  proper- 
ly be  given  and  draft  a  qualification  applicable  to  that  case. 

Inst.  Ex.  1917. 

2.  What  are  the  essentials  of  an  audit  certificate  in  an 
audit  for  credit  purposes?  Inst.  Ex.  1917. 

3.  Draft  a  form  of  audit  certificate  to  accompany  a  Balance 
Sheet  which  is  to  be  published  in  the  annual  report  of  a  cor- 
poration. Inst.  Ex.  1918. 

4.  Draw  up  an  outline  of  a  report  on  your  audit  of  the 
accounts  of  a  corporation  that  has  recently  erected  a  large  apart- 
ment house.    Assume  your  instructions  covered  the  period  of 
erection  and  at  least  one  year  of  operation.  Inst.  Ex.  1918. 

5.  Give  your  opinion  of  the  following  form  of  certificate 
to  a  Balance  Sheet : 

"I  have  examined  the  above  Balance  Sheet  and  certify   that    it 
*        is  in  accordance  with  the  books  of  the  Company." 

(Signed)  CHARLES  E.  WILSON 

C.  P.  A.  111. 

6.  If  employed  by  the  officers  of  a  corporation  to  make  an 
audit,  would  you  make  any  difference  in  your  plans  and  in  your 
report  if  you  knew  whether  the  audit  was  to  be  presented  to  a 
prospective  purchaser  of  the  stock,  to  a  prospective  purchaser  of 
bonds,  to  the  bank  as  a  basis  for  the  purpose  of  securing  a  loan, 
or  to  the  stockholders  at  their  regular  annual  meeting?     If  so, 
state  the  differences.  C.  P.  A.  Mich. 


B.    ACCOUNTING  PROBLEMS 

i.  From  the  following  accounts  appearing  on  the  Trial 
Balance,  prepare  without  using  figures,  statements  which  you 
consider  best  calculated  to  set  forth  the  operations  of  the  year 
and  the  financial  position  at  December  31,  1916,  assuming  that 
you  are  preparing  these  statements  on  behalf  of  a  bank  which 
desires  paper  available  for  rediscount  with  the  federal  reserve 
bank. 


Accounts  payable 

Accounts  receivable 

Advertising 

Buildings 

Capital  stock 

Capital  stock  unsubscribed 

Cash  on  deposit 

Commissions  paid  salesmen 

Depreciation   buildings    1916 

Depreciation  machinery  1916 


Discount  allowed  on  sales 

Discount  rec'd.  on  purchases 

Doubtful  accounts  receivable 

Factory  expense 

Finished  goods  inv.  12-31-15 

Freight  and  cartage  inward 

Freight  and  cartage  outward 

Fuel 

Good  will 

Insurance  bldgs.    and    mach. 


ACCOUNTING  PROBLEMS 


237 


Insurance  finished  goods 
Insurance  unexpired  buildings 

and  machinery 
Insurance  unexpired  finished 

goods 

Int.    accrued  on  investments 
Int.  accrued  on  mortgage  pay. 
Interest  paid 
Interest  received 
Investments 
Labor  factory  payroll 
Land 

Machinery 

Material  inventory    12-31-15 
Material  purchased 
Mortgage  on  plant 
Notes  payable 
Notes  receivable 
Office  expenses 

Office  furniture  and  fixtures 
Office  payroll 
Organization  expenses  (to  be 

distributed       over       three 


years  from  January  I,  1916) 
Payroll  factory  accrued 
Payroll  office  accrued 
Petty  cash 

Prepaid  taxes  and  real  estate 
Profit  and  loss  1915  surplus 
Repairs  buildings 
Repairs  machinery 
Res.  for  bad  and  dbt.  accounts 
Reserve    for   depr.   buildings 
Res.     for     depr.     machinery 
Returns   and    allowances   on 

sales 

Salaries  general  officers 

Salaries  salesmen 

Sales 

Salesmen  accounts — advances 

on  salaries 

Subscriptions  and  donations 
Taxes  income  U.  S. 
Taxes  real  estate 
Work  in  process  inv.  12-31-15 


The  inventories  December  31,  1916,  not  on  the  books  were: 
Finished  goods  Material  work  in  process 

Inst.  Ex.   1917. 


2.     The  following  is  the  Balance  Sheet  of  the  A.  B.  Company 
January  I,  1915: 


Cash 

Accounts  receiv- 
able   

Inventories: 
Raw  material. . 
Finished  goods. 

Office  furniture 
and  fixtures.  .  . 

Land 

Buildings 

Machinery 


$  52,864.00 
197,425.00 

84,268.00 
31,597-00 

7,500.00 
180,000.00 
150,000.00 
250,000.00 


Accounts  payable  $35,482 .  oo 
Dividends  payable 

pfd.  stock  2-1-15  7,500.00 
Dividends  payable 

com. stock 2-1-15  IO.OOO.OO 
Mortgage  bonds 

2O-year    6     %, 

dated  Jan.  i,- 1 5  100,000.00 
Premium  on  bonds  5 ,000 .  oo 
Capital  stock  pfd.  250,000 .  oo 
Capital  stock  com.  500,000.00 
Res.  for  bad  debts  4,718.00 
Surplus 40,954.00 


$953,654.00 


$953-654-00 


238  PUBLIC  ACCOUNTING  AND  AUDITING 

The  transactions  for  the  year  ending  January  i,  1916,  have 
been  as  follows: 

Cash  received  from  customers $793,501 .00 

Rent  received 600 .  oo 

There  has  been  purchased 

1,232,000  Ibs.  raw  material  at  20  cents  per  Ib. 

Sales  have  been 823,334.00 

Discount  and  allowances  on  sales 23,519.00 

Bad  debts  written  off 2,143 . oo 

Disbursements  have  been  made  for 

Accounts  payable 243,356.00 

Factory  expense 7489 . 00 

Factory  labor 351,426.00 

Factory  repairs 23,843 .  oo 

Office  expense i  ,927 .  oo 

Selling  expense 52,914.00 

Salaries 58,471 .  oo 

Taxes 7,853 .  oo 

Inventories  January  i,  1916 

Raw  material  412,595  Ibs.  having  a  market 
value  of  22  cents  per  Ib.  and  finished  goods 
$30,842.00.  The  land  is  estimated  to  be 
worth  $200,000.00. 

Semi-annual  dividends  of  3  per  cent  on  pre- 
ferred and  2  per  cent  on  common,  declared 
in  June  and  December,  payable  August  i 
and  February  i.  Reserves  for  deprecia- 
tion of  buildings  3  per  cent;  machinery  5 
per  cent;  office  fixtures  10  per  cent.  Bad 
and  doubtful  debts  reserve  should  be  2 
per  cent  of  accounts  receivable. 

Prepare  Statement  of  Cost  of  Goods  Manufactured  and 
Sold,  Profit  and  Loss  statement,  and  Balance  Sheet  as  of  January 
I,  1916.  Inst.  Ex.  1917. 

(Note.  Beginning  with  the  Balance  Sheet  at  January  I,  1915,  it  will 
be  necessary  to  carry  the  transactions  of  the  year  through  working  papers 
or  to  set  up  skeleton  ledger  accounts  in  order  to  obtain  the  balances  of  the  ac- 
counts which  form  the  basis  of  the  statements  at  January  I,  1916.) 


PRACTICE  DATA  239 

PRACTICE  DATA 

(Continued  from  Chapter  Fourteen) 

Transaction  No.  13.  You  have  now  completed  your 
audit  of  the  books  of  the  General  Manufacturing  Company, 
but  you  should  prepare  a  Working  Sheet  similar  in  form  to  the 
one  illustrated  on  pages  216  and  217.  This  should  be  done  in 
the  office  of  the  client  because  it  is  frequently  nesessary  to 
secure  additional  information.  If  one  were  to  prepare  the 
Working  Sheet  in  his  own  office,  which  might  be  at  some  distance 
from  the  office  of  the  client,  it  would  readily  be  seen  that  it 
would  be  inconvenient,  and  sometimes  impossible,  to  secure 
the  information  needed. 

Remember  that  the  Working  Sheet  as  prepared  by  an 
auditor  is  not  to  be  confused  with  what  was  formerly  known 
as  a  six-column  statement.  The  ledger  accounts,  as  set  up  by 
you,  show  a  proper  summary  of  all  the  real  and  nominal  accounts, 
consequently  the  Trial  Balance  prepared  by  you,  as  instructed 
in  Transaction  No.  n,  is  the  same  as  will  appear  in  the  first 
two  columns  of  your  Working  Sheet.  The  journal  entries  set 
up  in  accordance  with  the  instructions  in  Transaction  No.  12 
will  naturally  be  entered  in  the  adjustment  columns  of  the 
Working  Sheet.  After  this  has  been  done,  you  are  ready  to 
extend  all  of  the  accounts  into  the  proper  columns,  classifying 
them  as  either  nominal  or  real  accounts.  After  the  Working 
Sheet  is  prepared  your  work  in  the  office  of  the  client  is  completed. 

Transaction  No.  14.  You  are  now  instructed  to  prepare 
a  report  for  your  client,  the  General  Manufacturing  Company 
based  on  your  completion  of  the  audit  of  their  books.  This 
report  should  consist  of  the  following: 

Exhibit  "A"— Balance  Sheet. 

Exhibit  "B" — Statement  of  Profit  and  Loss. 

Schedule  "B-i" — Statement  of  Cost  of  Sales. 

Comments. 

« 

Certificate. 

Transaction  No.  15.  Your  client  requests  that  you 
prepare  closing  journal  entries  to  properly  close  the  nominal 
accounts  as  at  the  close  of  business,  Dec.  31,  1920.  His  book- 
keeper will  then  post  the  closing  entries  to  the  proper  ledger 
accounts. 


Appendix 


ACCOUNTING  TERMINOLOGY 

Applicants  have  been  asked  to  define  the  following  account- 
ing terms  in  the  examinations  given  in  the  various  states  since 
the  first  law  was  passed  in  New  York  in  1896  recognizing  account- 
ancy as  a  profession.  The  definitions  presented  here  are,  in 
part,  those  prepared  by  the  Committee  on  Terminology  appointed 
by  the  American  Association  of  Public  Accountants.  This 
Committee  was  made  up  of  the  following  members,  all  of  whom 
are  Certified  Public  Accountants: 

J.  Lee  Nicholson,  Chairman 
Hamilton  S.  Corwin, 
Henry  B.  Fernald, 
John  R.  Wildman. 

Terms  not  defined  by  the  above  Committee,  but  which 
have  been  used  in  the  examinations  are  herein  defined,  and  the 
definitions  given  are  those  sanctioned  by  the  best  accounting 
authorities. 

Abeyance.  Held  in  suspense  for  future  settlement  or 
adjustment. 

Abstract  of  Postings.  A  list  of  ledger  postings  such  as 
one  drawn  off  for  the  purpose  of  proving  the  postings  in  the 
ledger  with  the  books  of  original  entry  or  for  special  information. 

Acceptance,  (i)  An  agreement  to  pay  a  bill  of  exchange, 
draft,  order  or  kindred  instrument  on  the  terms  stated  therein. 
(2)  The  document  itself  when  bearing  on  its  face  the  evidence 
of  its  acceptance. 

Accommodation.  A  loan  of  money  or  endorsement  of 
another  person's  paper  as  a  favor. 

Accommodation  Paper.  Instruments  which  a  maker, 
drawer,  acceptor  or  indorser,  having  no  interest  in  the  trans- 
action, signs  merely  as  an  accommodation  to  another. 

Account.  An  entry  or  group  of  entries,  either  debits  or 
credits  or  a  combination  of  both,  under  a  specific  or  descriptive 
heading,  exhibiting  the  history  and  results  of  the  transactions 
pertaining  thereto. 

241 


242  PUBLIC  ACCOUNTING  AND  AUDITING 

Account  Current.  A  running  record  of  current  financial 
transactions  between  two  parties  who  may,  through  the  growth 
of  their  account,  become  debtor  or  creditor  alternately. 

Account  Sales.  A  statement  giving  an  accounting  of 
goods  sold,  rendered  by  a  consignee  to  the  consignor. 

Account  Receivable.  An  account  showing  a  debit  bal- 
ance to  be  presently  received  in  cash  or  its  equivalent. 

Account  Payable.  An  account  showing  a  credit  balance 
to  be  presently  paid  in  cash  or  its  equivalent. 

Accountability.  That  relation  which  exists  between  two 
parties  by  virtue  of  which  one  is  required  to  account  to  the 
other  for  money  or  property. 

Accountancy  is  a  profession  having  to  do  with  the  record- 
ing, verification  and  presentation  of  facts  involving  the  acqui- 
sition, production,  conservation  and  transfer  of  values. 

Accountant.     One  skilled  in  the  science  of  accounting. 

Accounting.  Accounting  is  the  science  which  treats  of  the 
systematic  record,  compilation  and  presentation  in  a  compre- 
hensive manner  of  the  financial  operations  of  a  business. 

Accrual,  (i)  The  act  of  accruing.  (2)  That  portion  of 
an  accruing  account  not  yet  due  applicable  to  the  accounts 
of  the  period  under  consideration. 

Accrue,  (i)  To  accumulate  automatically  through  lapse 
of  time.  (2)  To  set  up  or  record  a  debit  or  credit  automatically 
accumulating  through  lapse  of  time. 

Accrued  interest  receivable  or  payable  is  the  amount  of 
accruals  of  interest  on  various  classes  of  assets  or  liabilities. 

Accrued  taxes  is  the  amount  of  accruals  of  taxes. 

Accrued  dividends  (or  accumulated  dividend)  is  the  amount 
of  accruals  of  dividends  receivable  or  payable  on  guaranteed 
or  cumulative  stocks  owned,  issued  or  guaranteed. 

Active  Account.  An  account  in  which  the  entries  are 
frequent;  as  distinguished  from  an  "inactive"  account. 

Active  Partner.  A  partner  who  is  subject  to  full  part- 
nership liability  as  distinguished  from  a  "silent"  or  "special" 
partner,  whose  liability  is  limited. 

Additional  Capital.  New  capital;  i.  e.,  an  amount 
supplied  as  capital  increasing  that  previously  provided.  The 
term  "additional  capital"  refers  to  the  amount  coming  into  the 


ACCOUNTING  TERMINOLOGY  243 

business  as  distinguished  from  the  expenditures  made  in  increas- 
ing capital  investments.     (See  Additions  to  Capital.) 

Additions  to  Capital.  (A  contraction  of  "additions  to 
capital  investments.")  Expenditures  for  capital  account; 
"capital  expenditure."  The  amounts  expended  for  additional 
capital  assets,  such  as  structures,  machinery  or  permanent 
equipment. 

Adjustment  Account.  A  temporary  account  set  up  to 
show  a  record  of  the  items  of  a  transaction  or  series  of  transactions 
subject  to  and  pending  its  clearance  by  definite  classification 
or  by  adjustment  between  the  respective  interests  therein. 

Adjustment  Mortgage  Bonds.  Mortgage  bonds  issued 
under  a  modification  of  the  terms  of  a  previous  issue,  the  con- 
ditions of  which  the  debtors  have  been  unable  to  fulfill. 

Administration  Expenses.  Expenses  incurred  in  con- 
nection with  the  administration  of  a  business,  usually  the  salary 
and  expenses  of  the  executives  and  other  expenses  not  directly 
chargeable  to  specific  operating  or  selling  expenses. 

Administrator.  A  person  named  by  the  probate  court, 
or  other  proper  authority,  to  take  charge  of  the  property  and 
administer  the  estate  of  one  dying  without  leaving  a  will  or 
an  estate  for  which  no  competent  executor  is  named  in  the  will. 

Advance  Bill.  A  commercial  "bill  of  exchange"  drawn 
against  goods  subsequently  to  be  shipped  instead  of  against 
a  shipment  already  made. 

Advertising  Expense.  The  expense  of  attracting  the 
attention  of  the  public  to  a  business,  product,  proposition  or 
fact. 

Affiliated  Company  (or  Corporation.)  A  company  (or 
corporation)  related  to  another  through  stock  or  bond  owner- 
ship, operating  agreement  or  other  mutuality  of  interest. 

Agency,  (a)  The  relationship  between  principal  and  agent, 
(b)  The  place  of  business  of  an  agent. 

Agent.  A  person  duly  authorized  to  act  on  behalf  of 
another,  or  one  whose  unauthorized  act  has  been  duly  ratified. 

Allocate,  (a)  To  assign  items  to  their  appropriate  cap- 
tions in  a  classification  of  accounts,  (b)  To  classify. 

Allonge.  A  slip  of  paper  attached  to  a  negotiable  instru- 
ment to  receive  endorsement  for  which  there  is  no  space  on 
the  instrument  itself. 


244  PUBLIC  ACCOUNTING  AND  AUDITING 

Allowance,  (i)  A  concession  or  abatement.  Specifically 
in  accounting  usage,  a  concession  made  to  customers  because 
of  faults  existing  or  claimed  in  goods  or  service.  (2)  A  definite 
amount  granted  or  determined  upon  for  a  specific  purpose;  as 
an  allowance  for  depreciation,  an  allowance  in  lieu  of  actual 
expenses,  etc. 

Amortization.  The  gradual  extinguishment  of  the  amount 
of  an  asset,  liability,  profit  or  loss  by  pro-rating  it  over  the  period 
during  which  it  will  exist  or  during  which  its  benefit  will  be 
realized.  Specifically,  (i)  The  gradual  extinction  of  a  debt,  as, 
for  instance,  by  means  of  a  sinking  fund.  (2)  The  gradual 
reduction  in  the  valuation  of  an  asset,  thus  anticipating  the 
time  when  it  shall  eventually  become  worthless;  as  distinguished 
from  provision  for  depreciation  or  replacements  because  of 
physical  loss  or  damage.  (3)  The  absorption  in  the  Income 
or  Profit  and  Loss  accounts,  during  the  pendency  of  the  debt, 
of  a  discount  incurred  or  of  a  premium  realized  in  the  sale  of 
an  obligation,  which  discount  or  premium  may  be  carried  in 
the  meantime  in  a  debit  or  in  a  credit  Suspense  account. 

Annuity.  A  fixed  sum  of  money  granted  or  bequeathed, 
payable  yearly  or  at  certain  regular  periods. 

Appraisal.  The  result  of  a  valuation  of  property  or  other 
assets,  used  mostly  in  connection  with  the  valuation  of  fixed 
assets  of  a  corporation. 

Appreciation.  Increase  in  value  through  improvement 
in  condition  or  market  value,  applied  in  respect  of  real  estate, 
plant,  machinery,  securities,  etc. 

Assigned  Accounts.  Accounts  originally  due  to  one 
person  who  has  by  agreement  made  them  payable  to  some 
other  person,  usually  his  creditor. 

Auditor.  An  accountant  who  examines,  criticizes  and 
passes  upon  the  accuracy  of  accounts. 

Balance  Sheet.  A  statement  showing  the  financial  con- 
dition of  a  business  at  a  specific  date. 

Balance  Sheet  Audit.  A  verification  of  the  assets  and 
liabilities  and  a  sufficiently  exhaustive  analysis  of  the  Profit 
and  Loss  accounts  enabling  the  auditor  to  certify  that  the  sur- 
plus appearing  in  the  Balance  Sheet  is  reasonably  correct. 

Bank  of  Discount.  A  bank  authorized  by  law  to  lend 
money  on  personal  notes.  The  term  bank,  as  used  here,  means 
any  moneyed  corporation  authorized  by  law  to  issue  bills,  notes, 
or  other  evidences  of  debt  for  circulation  as  money,  or  to  receive 
deposits  of  money  and  commercial  paper  and  to  make  loans 


ACCOUNTING  TERMINOLOGY  245 

thereon,  and  to  discount  bills,  notes,  or  other  commercial  paper 
and  to  buy  and  sell  gold  and  silver  bullion  or  foreign  coins  or 
bills  of  exchange.  (N.  Y.  State  Banking  Law.) 

Book  Inventory.  A  record  of  all  goods  put  into  and 
taken  out  of  stock,  and  the  balance  remaining  on  hand.  It 
always  shows  quantities  and  must  also  show  values  if  the  cost 
records  are  articulated  with  the  general  books. 

Budget.  A  statement  of  the  estimated  revenues  and 
expenditures  for  a  given  future  period. 

Capital.  This  term  as  used  in  accounting  is  employed 
to  express  the  sum  of  the  net  assets,  or  the  sum  which  remains 
after  deducting  the  total  liabilities  from  the  total  assets  of  a 
business  or  undertaking. 

Any  principal  sum  (usually  in  cash,  sometimes  in  property) 
contributed  to  an  undertaking  by  a  partner  or  other  individual 
for  supplying  the  means  to  operate  such  undertaking. 

The  value  or  amount  any  individual  has  invested  in  an 
undertaking. 

Any  principal  sum  which  is  used  or  retained  to  produce 
income  or  profit. 

Capital  Assets.  Includes  real  estate,  buildings,  and 
other  structures,  equipment  and  other  personal  property  of  a 
more  or  less  permanent  character,  and  cash  on  hand  specifically 
applicable  to  these  assets. 

Capital  Expenditures.  All  sums  expended  for  addition 
to,  or  improvement  of,  properties. 

Capital  Liabilities.  Liabilities  incurred  in  the  acquisi- 
tion of  capital  assets. 

Capital  Receipts.  Cash  received  from  stockholders  in 
a  corporation  in  payment  of  their  subscriptions  to  the  capital 
stock. 

Capital  Stock.  The  amount  of  share  capital  (issued  or 
authorized)  of  a  company  or  corporation. 

Cash.  Lawful  money.  Usually  understood  to  include 
cash  items  and  such  other  instruments  as  are  received  by  banks 
for  deposit. 

Cash  Disbursements.  Cash  payments  made  during  a 
stated  period  regardless  of  the  purpose  of  the  payment. 


246  PUBLIC  ACCOUNTING  AND  AUDITING 

Cash  Journal.  A  book  of  original  entry  in  which  both 
cash  and  non-cash  entries  are  recorded.  Columns  are  provided 
for  cash  receipts,  cash  payments,  and  for  accounts  most  frequently 
debited  and  credited.  Sundry  debit  and  credit  columns  are 
also  provided. 

Cash  Receipts.  Cash  received  during  a  stated  period 
regardless  of  the  purpose  for  which  received. 

Chattel  Mortgage.  A  lien  upon  personal  property,  given 
by  the  owner  as  security  for  the  payment  of  a  debt  or  the  per- 
formance of  some  other  obligation.  Upon  default,  such  lien 
may  be  perfected  into  an  absolute  title  by  foreclosure  and  sale. 

Closing  Entries.  Entries  made  upon  the  books  of  ac- 
count at  the  end  of  a  fiscal  period  for  the  purpose  of  closing 
the  nominal  accounts. 

Consignment  Accounts.  Those  accounts  which  cover 
the  consignment  of  goods  to  an  agent  or  consignee. 

Consolidated  Balance  Sheet.  A  Balance  Sheet  which 
exhibits  the  combined  financial  condition  of  a  number  of  business 
organisations. 

Construction  Account.  An  account  employed  to  show 
the  cost  of  construction  of  a  piece  of  property.  It  is  usually 
made  to  contain  all  items,  such  as  material,  labor,  expense, 
entering  in  the  work;  in  some  cases  interest  on  borrowed  money 
is  charged  against  this  account  and  even  the  discount  on  the 
sale  of  bonds  issued  for  the  work. 

Contingent  Fund.  Money  set  aside  to  be  drawn  upon 
only  in  case  of  certain  emergencies. 

Contingent  Liability.  An  amount  which  may  become 
due  usually  through  the  default  or  action  of  a  third  party. 

Controlling  Account.  An  account  kept  in  the  general 
ledger  which  represents  in  one  account  the  sum  of  all  the  trans- 
actions, and  of  all  the  balances  of  a  group  of  accounts  in  a  sub- 
sidiary ledger,  or  other  record  such  as  a  voucher  payable  record. 

Costs  Incurred.  All  expenditures,  whether  paid  in  cash 
or  not,  for  which  a  business  has  become  liable. 

Current  Assets.  Those  assets  which  can  be  readily  con- 
verted into  cash. 

Current  Liabilities.  Amounts  owed  subject  to  constant 
change,  such  as  accounts  payable  to  creditors,  becoming  due 
and  payable  in  short  periods. 


ACCOUNTING  TERMINOLOGY  247 

Deferred  Charges  to  Operations.  That  part  of  oper- 
ating expenditures  which  is  paid  within  a  given  period  but  is 
not  properly  a  charge  against  the  income  of  that  period  and, 
therefore,  is  deferred  or  postponed  uatil  a  period  following. 

Deferred  Credit.  That  part  of  revenue  which  is  received 
within  a  certain  period,  but  is  not  properly  a  credit  to  the  income 
for^that  period,  and,  therefore,  is  deferred  or  postponed  until  a 
period  following. 

Deferred  Debit.  That  part  of  expenditures  which  is  paid 
within  a  certain  period,  but  is  not  properly  a  charge  against  that 
period  and,  therefore,  is  deferred  or  postponed  until  a  period  fol- 
fowing. 

Deficiency  Account.  An  account  relative  to  a  statement 
of  affairs,  showing  the  causes  for  the  prospective  deficiency  in 
the  payments  to  the  unsecured  creditors  of  an  insolvent  concern. 

Departmental  Accounts.  A  system  of  accounts  which 
covers  the  separate  workings  of  the  departments  of  any  concern 
usually  in  relation  to  the  profit  or  loss  made  by  such  departments. 

Depreciation.  That  inevitable  lessening  in  value,  which 
is  inherent  in  any  fixed  asset,  caused  by  wear  and  tear  and 
gradual  obsolescence. 

Depreciation  Fund.  Cash  or  other  assets  set  aside  to 
provide  for  depreciation  of  plant,  property,  etc. 

Depreciation  Reserve.  A  part  of  the  earnings  set  aside 
and  carried  as  a  credit  to  offset  any  deterioration  of  assets  which 
has  taken  place  or  is  likely  to  arise. 

Diminishing  or  Wasting  Assets.  Assets  which  dimin- 
ish proportionately  to  the  lapse  of  time  or  to  their  consumption 
as  an  element  of  production. 

Disbursements.  Cash  payments  made  during  stated 
period,  regardless  of  the  purpose  of  the  payment. 

Dividend  Account.  The  controlling  account  in  the  gen- 
eral ledger  of  any  corporation  to  which  is  credited  the  amount 
of  dividend  on  the  day  of  declaration  and  to  which  are 
charged  checks  issued  in  payment  thereof,  either  "en  bloc"  or 
as  they  may  be  presented  for  payment. 

Effective  Interest  Rate.  The  ratio  of  the  amount  earned 
to  the  actual  amount  of  money  invested,  as  distinguished  from 
the  nominal  rate  which  is  figured  on  the  par  value  of  the  bond 
or  other  investment. 

Effective  Rate.     (See   "Effective   Interest   Rate.") 


248  PUBLIC  ACCOUNTING  AND  AUDITING 

Financial  Statement.  A  Balance  Sheet.  Sometimes 
taken  to  include  all  other  statements,  such  as  a  statement  of 
affairs,  a  statement  of  income  and  expenditures,  and  a  statement 
of  profit  and  loss. 

Finished  Product.  The  article  of  trade  of  a  manufactur- 
ing concern  which  has  been  completed  and  is  ready  for  sale. 

Fixed  Assets.  Such  assets  as  are  stationary  and  may  be 
regarded  to  a  certain  extent  as  permanent,  such  as  real  estate, 
buildings,  plant,  machinery,  etc.  The  term  "Fixed  Assets" 
and  "Fixed  Capital"  are  frequently  interchanged,  but  preference 
is  given  to  the  former  term. 

Fixed  Charges.  Charges  which  remain  comparatively 
unchanged  during  long  periods  of  time,  such  as  interest  on 
bonds,  debentures,  etc. 

Fixed  Liabilities.  The  permanent  or  ultimate  obliga- 
tions as  distinct  from  the  current  obligations  (or  floating  in- 
debtedness) of  a  person,  firm,  or  corporation. 

Floating  Assets.  Same  as  liquid,  sometimes  called  "Cir- 
culating Assets." 

Floating  Capital.  Capital  which  is  not  in  a  fixed  or 
permanent  shape,  but  is  available  or  convertible,  such  as  raw 
material,  book  debts,  cash,  etc. 

Floating  Debt,  (i)  That  portion  of  a  debt  of  a  corpora- 
tion or  undertaking  which  is  not  represented  by  a  bond  issue. 
(2)  General  or  ordinary  indebtedness. 

Floating  Liabilities.  Amounts  which  are  due  to  others 
or  are  about  to  become  due,  as  creditors'  accounts  and  bills 
payable. 

Funded  Debt.  That  portion  of  a  debt  which  is  repre- 
sented by  a  bond  issue  and  payable  at  a  distant  date. 

General  Balance  Sheet.  A  Balance  Sheet  by  totals, 
i.  e.,  one  which  shows  the  financial  condition  of  a  company  by 
group  accounts  without  regard  to  detail. 

Good  Will.  Good  will  represents  the  value  attached  to 
a  business  over  and  above  the  value  of  the  physical  property. 

Hypothecate.     To  pledge  or  mortgage. 

Impersonal  Accounts.  Accounts  which  represent  con- 
dition and  record  the  profits,  losses,  receipts,  expenditures, 
assets,  and  liabilities,  but  do  not  represent  persons. 


ACCOUNTING  TERMINOLOGY  249 

Imprest  System.  A  system  for  making  petty  cash  dis- 
bursements whereby  the  petty  cashier  is  reimbursed  for  the 
exact  amount  disbursed,  the  original  amount  of  the  petty  cash 
fund  remaining  unaltered.  The  reimbursing  check  is  charged 
to  the  proper  expense  accounts  for  which  the  petty  cash  payments 
have  been  made. 

Income.  The  account  which  sets  forth  the  entire  income 
for  a  fixed  period  whether  actually  received  or  not. 

The  gain  which  proceeds  from  property,  from  manufac- 
turing and  selling,  or  from  buying  and  selling. 

The  remuneration  derived  from  skill  or  labor. 
The  proceeds  of  the  property  of  an  estate. 

Income  Bond.  A  long-term  promissory  note,  the  interest 
on  which  is  payable  out  of  income  if  earned. 

Interest  Account.  A  revenue  account  to  which  is  debited 
and  credited  interest  incurred  or  earned  whether  paid  or  not. 

Inventory,  (i)  The  annual  account  of  stock  of  a  business. 
(2)  A  schedule  of  assets  or  property.  (3)  An  itemized  list  of 
goods  or  valuables  with  prices  attached. 

Joint  Venture  Account.  An  account  covering  a  specific 
shipment  of  consigned  goods  to  be  sold  for  the  benefit  of  two 
or  more  parties. 

Legal  Assets.  Property  which  creditors  might  make 
available  in  a  court  of  law  for  the  payment  of  the  debts  of  a 
deceased  person. 

Life  Tenant.  The  beneficiary  under  a  will  who  enjoys 
the  income  from  an  estate  during  life. 

Liquid  Assets.  Cash  and  such  assets  as  can  readily  be 
converted  into  cash. 

Loose-Leaf  System.  A  binding  device  which  permits 
the  insertion  and  removal  of  sheets  as  desired.  It  is  not  a 
distinctive  system  of  accounting.  Either  the  books  of  original 
entry  or  the  ledgers  may  be  kept  in  loose-leaf  form  if  desired. 

Maintenance  Reserves.  A  reserve  to  which  may  be 
charged  expenses  in  connection  with  maintaining  some  asset 
for  which  the  reserve  has  been  created. 

Manufacturing  Account.  An  account  subsidiary  to  the 
Profit  and  Loss  account  for  the  purpose  of  showing  the  result 
of  factory  operations  as  distinguished  from  trading  operations. 


250  PUBLIC  ACCOUNTING  AND  AUDITING 

Material  Account.  An  account  used  to  control  the 
amount  of  material  on  hand  in  a  manufacturing  concern.  The 
account  is  charged  with  purchases  and  credited  with  issues  to 
factory.  The  balance  should  agree  with  the  inventory  of  ma- 
terial. 

Merchandise  Account.  An  account  intended  to  rep- 
resent the  trading  transactions  of  a  business,  and  to  exhibit 
gross  profit  made  on  same.  An  account  to  which  is  charged 
the  purchases  of  material  to  be  sold  or  used  in  manufacture, 
and  to  which  may  be  credited  the  materials  sold  or  used. 

National  Bank  Notes.  Promissory  notes  issued  by  na- 
tional banks  and  circulating  as  money.  Such  notes  are  fully 
secured  by  United  States  bonds  purchased  by  the  issuing  bank 
and  deposited  in  the  United  States  Treasury. 

Net  Income.  After  all  costs  of  operation  and  fixed 
charges  of  every  kind  have  been  deducted  from  the  earnings 
of  a  corporation,  the  balance,  which  is  the  amount  available 
for  dividends,  may  be  called  "net  income". 

Net  Profit.  The  balance  remaining  after  all  expenses 
of  distribution  and  establishment  charges,  discount,  interest, 
etc.,  have  been  deducted  from  the  gross  profits. 

The  balance  of  the  Profit  and  Loss  account  when  the  same 
is  a  gain. 

The  surplus  remaining  over  from  the  employment  of  capital 
after  defraying  all  the  expenses  and  outlay  incurred  in  its  em- 
ployment, and  after  the  capital  has  been  replaced  or  provision 
made  for  its  replacement. 

Nominal  Accounts.  Accounts  which  represent  income 
or  expenses.  Accounts  used  for  the  purpose  of  classifying 
income  and  expenses  under  such  heads  as  rent,  taxes,  sales, 
purchases,  salaries,  etc.,  forming  the  material  for  the  construc- 
tion of  the  Profit  and  Loss  statement. 

Nominal  Interest  Rate.  The  rate  of  interest  on  bonds 
figured  on  the  par  value  of  the  bond. 

Operating  Expense.  The  expense  incurred  in  the  reg- 
ular transactions  of  a  business. 

Overhead  Expense  or  Burden.  Elements  of  cost  which 
cannot  be  definitely  assigned  to  any  particular  job,  or  series 
of  jobs,  but  are  a  part  of  the  expense  of  manufacture,  and 
must  be  taken  into  account  in  calculating  costs. 


ACCOUNTING  TERMINOLOGY  251 

Organization  Expenses.  Expenses  which  are  necessarily 
incurred  before  a  corporation  can  begin  to  do  business.  They 
include  such  things  as  the  legal  and  other  fees  for  obtaining 
the  charter,  the  expense  of  obtaining  subscriptions  to  the  stock, 
and  sometimes  the  comission  paid  to  brokers  for  selling  the 
stock.  Charging  discount  on  stock  sold  below  par  to  this  account 
is  a  questionable  practice  sometimes  indulged  in. 

Pay  Roll  Advances.     Wages  paid  in  advance. 

Personal  Account.  Accounts  showing  the  transactions 
with  persons,  as  customers'  and  creditors'  accounts. 

Plant  Accounts.  An  account  the  debit  balance  of  which 
represents  the  value  of  land,  buildings,  and  sometimes  machinery 
and  fixtures,  of  a  business  concern. 

Present  Worth  of  Deferred  Payment.  An  amount 
which  if  put  at  interest  will  at  maturity  amount  to  the  deferred 
payment. 

Profit  and  Loss  Account.  A  summary  account  showing 
the  income  and  losses  during  a  given  period. 

Proprietary  Interest.  The  interest  of  a  proprietor  or 
partner.  A  partner  has  a  proprietary  interest  in  all  of  the  assets 
of  the  firm. 

Purchases  Ledger.  A  subsidiary  ledger  containing  ac- 
counts with  creditors — accounts  payable — usually  controlled 
by  an  account  in  the  general  ledger. 

Qualified  Certificate.  A  certificate  that  does  not  state 
positive  facts  as  the  results  of  an  audit,  but  contains  some 
clause  or  expression  which  is  intended  to  limit  the  responsibility 
of  the  auditor  in  regard  to  some  one  or  more  items,  the  accuracy 
of  which  he  has  not  been  able  to  verify. 

Real  Account.  Represents  the  value  of  an  actual  asset, 
or  the  amount  of  an  actual  liability,  such  as  real  estate,  ma- 
chinery, loans,  and  mortgages. 

Realization  and  Liquidation  Account.  An  account 
showing  the  result  of  the  liquidation  of  a  business  or  estate. 

Redemption  Fund.  A  fund  accumulated  for  the  pay- 
ment of  redeemable  debentures,  funded  debt,  or  other  obliga- 
tions. 

Remainderman.  The  beneficiary  under  a  will  to  whom 
the  estate  passes  at  the  death  of  an  intermediate  party,  called 
the  life-tenant,  who  enjoys  the  income  from  said  estate  through- 
out life. 


252  PUBLIC  ACCOUNTING  AND  AUDITING 

Reserve  Fund.  Cash  set  aside  out  of  the  general  funds, 
usually  measured  by  a  reserve  (credit),  both  the  fund  and  the 
reserve  being  created  for  some  specific  purpose.  The  reserve 
(credit)  represents  the  profits  withheld,  while  the  fund  shows 
the  amount  of  cash  available  for  the  specific  purpose. 

Revenue  Account.  An  account  which  relates  to  profits 
and  losses,  income  and  expenditures,  as  distinguished  from 
capital  accounts  which  relate  to  assets  and  liabilities. 

Revenue  Accrued.  That  which  has  been  earned  since 
the  last  receipt  of  revenue  but  is  not  due  and  has  not  been 
received. 

Revenue  Balance  Sheet.  In  municipal  accounting,  a 
Balance  Sheet  of  current  assets  and  liabilities,  showing  cash 
and  amounts  due  from  current  revenues  and  the  liability  thereon 
due  to  appropriations. 

Revenue  Expenditures.  Expenditures  made  in  connec- 
tion with  the  running  expenses  of  the  legitimate  business  of 
the  firm  or  corporation  concerned.  Expenditures  that  only 
have  the  effect  of  putting  the  earning  power  of  the  undertaking 
upon  the  same  footing  as  that  which  had  previously  obtained, 
must  be  charged  against  revenue. 

Revenue  Receipts.  They  are  distinguished  from  capital 
receipts  by  being  exclusively  derived  from  the  sale  or  exchange 
of  the  commodities  which  the  company  was  organized  to  buy 
and  sell,  the  excess  of  receipts  over  expenditures  constituting 
net  profit  or  added  actual  capital.  Receipts  derived  as  the 
direct  result  of  trading,  as  distinguished  from  capital  receipts 
resulting  from  the  sale  of  capital  stock,  or  proceeds  of  bonds, 
mortgages,  etc. 

Secret  Reserves.  Values  of  assets  in  excess  of  those 
indicated  by  the  Balance  Sheet. 

Serial  Bonds.     An  issue  of  bonds  payable  in  instalments. 

Shipment  Account.  Corresponds  to  "Adventure  Ac- 
count," but  is  the  account  on  the  books  of  the  consignee. 

Single  Name  Paper.  A  note  for  which  a  single  indivi- 
dual, firm,  or  corporation  is  responsible  for  payment;  a  note 
bearing  but  one  signature  and  without  endorsers. 

Sinking  Fund.  A  certain  sum  set  aside  each  year,  that 
accumulated  at  compound  interest,  will  be  sufficient  to  provide 
for  the  payment  of  bonds  or  other  obligations  maturing  at 
some  future  time. 


ACCOUNTING  TERMINOLOGY  253 

Statement  of  Affairs.  An  exhibit  of  the  assets  and  the 
liabilities  of  an  insolvent  debtor,  so  arranged  as  to  show  on 
one  side  all  the  assets  of  the  concern  with  the  amounts  they 
are  expected  to  realize  extended  into  another  column,  and 
on  the  other  side  all  the  concern's  gross  liabilities  with  the 
amount  expected  to  rank  carried  into  a  separate  column. 

Statement  of  Assets  and  Liabilities.  A  statement 
of  financial  condition  of  a  solvent  concern,  where  the  books 
are  kept  by  single  entry,  is  best  designated  as  a  "Statement  of 
Assets  and  Liabilities." 

Statement  of  Income  and  Expense.  A  statement 
which  shows  the  income  earned  and  expenses  incurred  during 
a  certain  period,  it  being  immaterial  whether  or  not  the  items 
are  actually  received  or  disbursed  during  that  period. 

Statement  of  Receipts  and  Disbursements.  A  state- 
ment arranged  in  report  form,  showing  respectively  with  regard 
to  cash,  the  balance  at  the  beginning  of  a  period,  the  classified 
receipts  and  disbursements  during  the  period,  and  the  balance 
remaining  at  the  end  of  the  period. 

A  summarized  Cash  account,  stating  the  amounts  of  money 
actually  received  and  disbursed  during  the  period  to  which  it 
relates,  without  regard  to  whether  the  same  are  earnings  or 
expenses  exclusively  appertaining  to  that  period,  or  include 
items  so  appertaining  to  the  period  preceding.  It  starts  with 
the  cash  balance  at  the  commencement  of  the  period  which 
it  covers,  and  concludes  with  the  cash  balance  at  the  close 
thereof. 

Summary  Account.  An  account  into  which  a  number 
of  detail  accounts  are  closed  for  the  purpose  of  showing  a  general 
result. 

Surplus.  The  excess  of  assets  over  liabilities  including 
capital  stock.  It  is  in  reality  undistributed  profit. 

Surplus  Fund.  A  credit  account  formed  by  periodically 
setting  aside  a  portion  of  the  net  profits  of  a  corporation  to 
provide  an  unspecified  reserve  for  contingencies.  In  the  National 
Banking  Act,  a  fund  created  by  setting  aside  one-tenth  of  the 
net  profits  until  20%  of  the  capital  has  been  so  reserved  for 
dividends. 

Trading  Account.  This  account  shows  the  same  facts 
as  the  trading  accounts  on  the  Profit  and  Loss  statement,  and 
may  be  shown  as  a  separate  account,  or  as  one  section  of  the 
Profit  and  Loss  account.  All  accounts  relating  to  the  pur- 
chase and  sale  of  merchandise  are  usually  classed  as  trading 
accounts. 


254  PUBLIC  ACCOUNTING  AND  AUDITING 

Treasury  Stock.  Such  portion  of  the  capital  stock  of  a 
corporation  as  has  been  fully  paid  for  and  legally  issued  and 
has  since  been  acquired  by  the  issuing  corporation,  either  by 
purchase  or  by  donation. 

Trial  Balance.  A  Trial  Balance  is  a  list  of  the  balances 
or  footings  shown  on  a  ledger,  for  the  purpose  of  testing  their 
accuracy.  When  successfully  compiled,  it  ceases  to  be  a  trial 
balance  and  becomes  a  statement  of  ledger  balances. 

Two  Name  Paper.  A  note  made  by  two  persons  as 
individuals  or  made  by  one  and  endorsed  by  another — these 
two  persons  being  severally  liable. 

Undivided  Profits.  Earnings  or  profits  which  have  not 
been  divided  among  the  partners  in  a  firm  or  the  stockholders 
in  a  corporation. 

Voucher  Check.  A  check  which  contains  as  part  of  the 
instrument  a  statement  of  the  account  covered  by  the  check. 
It  is  used  in  connection  with  the  voucher  system  of  accounting 
for  expenditures. 

Voucher  System.  A  method  of  accounting  for  expen- 
ditures. The  vouchers  payable  book  shows  the  existing  liabili- 
ties and  serves  in  the  place  of  a  subsidiary  accounts  payable 
ledger.  A  controlling  account  is  kept  in  the  general  ledger  with 
Vouchers  Payable.  This  account  shows  the  total  of  unpaid 
vouchers. 

Will.  A  last  will  and  testament  and  all  codicils.  A  solemn 
declaration  in  legal  form  making  a  disposition  of  property  to 
take  effect  at  death,  but  revocable  during  life  by  the  person 
making  the  will. 

Working  Capital.  All  assets  available  for  the  carrying 
on  of  a  business,  such  as  cash,  accounts  receivable,  notes  receiv- 
able, and  inventories.  Those  assets  which  are  the  subject  of 
the  company's  business  or  may  be  easily  converted  into  cash. 


255 


INDEX 


Accounts 

bond 184 

bond  discount  and  expense.  185,  187 

bond  interest 185 

bond  premium 185 

bond  subscription 184 

building 122 

capital  stock,  discount 197 

capital  stock,  premium 197 

creditors' 161 

horses,  wagons  and  harness.  ...  133 

land 121 

machinery 130 

notes  payable 167 

office  furniture 133 

organization  expense 199 

purchases  ledger,  controlling.  . .  162 

tools  and  implements 131 

unissued  bond 184 

vouchers  payable,  controlling.. .  163 

Accounts  Assigned 84 

Accounts  Past  Due 84 

Accounts  Payable 161 

Accounts  Receivable 81 

Accounts  Outlawed 89 

Accountancy 9 

Accounting 9 

Accounting  Systems 

double  entry  bookkeeping 1 1 

single  entry  bookkeeping 10 

Accounting  Terminology 241-254 

Accrued  Liabilities 171 

Additions 134 

Adjusting  Entries 215,  216 

Advance  Payments 104 

Advice  to  Juniors 118 

Aging  Accounts 84 

Appraisement,  when  necessary.  . .  136 

Appreciation 153 

Auction  Sales 93 

Audits 

value  of 19 

kinds 

balance  sheet 23 

cash 22 

detailed 23 

internal 22 

purposes  and  advantages  of 

major  objects 8 

minor  objects 6 

Audit  Program 23,  101 

Auditor's  Report 225 

Auditor's  Responsibility 9,  227 

B 

Bad  Debts 84 

denned 87 

not  a  deduction .  .  86 


Balance  Sheet 38,  230,  231 

Bank  Certificate 57 

Beginning  an  Audit 17 

Bonds 

adjustments 181 

callable 182 

convertible 182 

coupon 181 

debenture 180 

deed  of  trust 179,  183 

gold 182 

guaranteed 181 

improvement 181 

income 180 

issuing,  procedure 

bond  issue  authorized 183 

directors'  meeting 183 

sale  of  bonds 184 

stockholders'  meeting 183 

mortgage 180 

participating 182 

purchase  money 181 

redeemable 182 

redeemed 188 

refunding 181 

registered 181 

security 179 

serial 182 

Bonus  Stock 202 

Book  Inventories 97 

Book  Variations 137 

Books  of  Account 

journal 33 

ledger 36 

notes  payable 167 


Capital  and  Revenue 

Expenditures 129 

Capital  Stock 204 

Cash 51 

Certificate,  the 166,  226,  227 

Classification  of  Accounts 

real. 25 

nominal 27 

Comments,  the  Auditor's  226,  234,  235 
Commercial  Law 

contact  with  accounting 12 

Commissions 172 

Common  Law 13 

Common  Stock 201 

Comparative  Statement 

Profit  and  Loss 214 

Completing  an  Audit 215 

Consigned  Goods 102 

Consignment  Purchases 165 

Constitutional  Law 13 

Construction  Work  in  Progress. .  .  .  135 


256 


Index — Continued 


Contingent  Fees 23 

Contingent  Liabilities 67,  169 

Controlling  Accounts 36,  162,  163 

Copartnership 193 

Corporation 194 

Correcting  Entries 215,  216 

Cost  of  Sales 210 

Cost  Systems 102,  103 

Counting  the  Cash 55 

Cumulative  Preferred  Stock 200 

Current  Liabilities. .        161 


D 


General  Reserve 151 

Goods  in  Transit 102 

Gross  Profit  on  Sales 210 

Gross  Profit  Test 103 

Guaranteed 210 

Guaranties 170 

H 

Horses,  Wagons  and  Harness 133 

How  to  End  an  Audit 215 


Damages 172 

Debenture  Stock 201 

Deductions  from  Income 211 

Deposits 84 

Depreciation 

basis  of 155 

causes 146 

defined 145 

factors 147 

Methods  of  Calculation 

annuity 149 

comparison  of 151 

diminishing  value 149 

production  unit 150 

rates 155 

straight  line 148 

Discounts 82,  84,  105 

Discrepancies 102 

Donated  Stock 202 

Doubtful  Accounts 83 


E 


Endorsements 170 

Engagement  Blank 17,  18 

Equipment 17 

Errors 

clerical 7 

of  commission 7 

of  omission 7 

of  principle 7 

offsetting 7 

Expenses 211 


Factory  Overhead  Cost 135 

Fire,  Merchandise 

Destroyed  by 100 

Fire,  Property  Destroyed  by 135 

Fixed  Assets 120,  129 

Fixed  Liabilities 177 

Forfeited  Stock 202 

Founders'  Stock 201 

Fraud 6,  45,  53 


Inadequate  Cost  Systems 102 

Income  Tax  Procedure 

adjustment  of  inventories 108 

assessments  not  deductible 125 

basis  of  depreciation 155 

capital  expenditures 

not  deductible 154 

depreciation,  a  deduction 154 

interest  on  Liberty  bonds 187 

inventories  at  cost 107 

inventories  at  market 108 

inventories  prescribed 109 

inventory  valuation,  basis 106 

rates  of  depreciation 155 

repairs  on  real  estate, 

deductible 126 

repairs  on  real  estate, 

not  deductible 126 

replacements  and  renewals 154 

taxes,  deductions 125 

valuation  of  inventories 107 

Installments,  Construction  Work.  135 

Interest  Not  a  Part  of  Cost 105 

Interest  on  Liberty  Bonds 187 

Interest  Payable 171 

Imprest  System 52 

Inventories 97 


Judgments 189 


Law  of  Contracts 

agreement 60 

alterations 45 

assignment  of  contracts 60 

breach  of  contract 61 

condition  concurrent 156 

condition  precedent 156 

condition  subsequent 156 

contracts  by  correspondence.  . .  157 

discharge 60 

essential  conditions 29 

illegal  contracts 45 

intervention  of  impossibility.  . .  6l 

legal  tender 6 1 


Index — Continued 


257 


methods  of  making  contracts. . .  29 

mistakes 45 

novation 60 

operation  of  law 61 

performance 60 

statute  of  frauds,  the 29 

Sunday  contracts 156 

tender 61 

unenforceable  contracts 45 

voidable  contracts 45 

Law  of  Personal  Property 

accession 139 

acquiring  title  to  personal 

property 139 

acquisition 139 

chattels 138 

intellectual  labor 139 

transfer  of  property 140 

Law  of  Real  Estate. , 124 

estate  in  fee  simple 124 

estate  for  life 124 

estate  in  remainder 124 

estate  in  reversion 124 

Leases 135 

Legal  Expense 172 

Legal  Responsibility  of  Client 24 

Legal  Tender 61 

Liberty  Bonds,  Interest  Exempt 

from  Taxation 187 

Letter  of  Introduction 17 

Listing  Notes  Receivable 67 

Listing  Securities 74 

M 

Machinery  Account,  Theory 130 

Manufacturing  Statement 213,  233 

Model  Balance  Sheet 40,  41 

Mortgages 189 

building  and  loan 178 

chattel 178 

purchase  money 178 

N 

Nature  of  Engagements 17 

Net  Worth 193 

Negotiable  Instruments 

Law,  the 172 

essentials 76 

non-essentials 77 

endorsements 

blank. 173 

conditional 173 

how  made 173 

qualified 173 

restrictive 173 

special 173 

striking  out 173 

Non-Cumulative  Preferred 

Stock 201 

Non-Participating  Preferred 

Stock 201 

Notes  Payable 166 


Notes  Payable  Book 167 

Notes  Receivable 65 

Notes  Receivable 

Discounted 66 

O 

Obsolete  Stock 103 

Office  Furniture  Account 133 

Opening  Entries, 

Corporation 203 

Other  Income .  211 


Participating  Preferred  Stock.  .  . .  201 

Part  Payments 89 

Payment  at  Maturity 89 

Pay  Roll 134 

Physical  Inventories 98 

Preferred  Stock 200 

Profit  and  Loss 209,  210 

Profit  and  Loss  Statement...  .212,  232 

Purchase  Contracts 165 

Purchases  Ledger  Account 162 

Purposes  of  the  Balance  Sheet ....  42 

0 

Qualifications  of  an  Auditor 8 


Real  Estate 120 

Real  Estate  Purchases 135 

Receipt 90 

Reconciling  the  Bank  Certificate. .     56 

Remedies 92 

Replacements  and  Renewals. ...     154 

Reports 225 

Reserves  for  Depreciation^,  151,  152 
Responsibility  of  Auditors     ...  .9,  227 


Sales 210 

Sales  Contract 90 

Sales  Ledger 81 

Securities 70 

non-speculative  investments ...  70 

permanent  investments 71 

sinking  fund  investments.       72,  188 

speculative  investments 70 

temporary  investments 70 

Schedules 134 

Share  Capital 194 

Sinking  Funds 188 

Sole  Proprietorship 193 

Specific  Reserve 152 

Statute  of  Frauds 39 

Statute  of  Limitations 89 

Stock  Corporations 194 

Stock  Issues 195 

Stock  of  No  Par  Value 195 

Stock,  No  Value 197 


258 


Index — Continued 


Stock  Sheets 101 

Subsidiary  Ledgers 36 

Subdivisions  of  Law 

common 13 

constitutional 13 

municipal 13 

statute 13 

Surplus 209 


Taxes 125,  171 

Tender 61 

Testing  the  Cost  System 103 

Terminology 66 

The  Work  of  the  Junior 5 

The  Work  of  the  Senior 6 

Theory  of  Accounts,  the 9 

Tools  and  Implements  Account.. .    131 

Trade  Acceptances  Payable 168 

Traveling  Expenses 172 

Treasury  Stock 202 

Trial  Balance,  the 37,  113 

Turnover 99,  105 


U 

Unfilled  Contracts 170 

Unpaid  Interest 189 

Unsalable  Stock 104 

Unstated  Liabilities 165 


Verification  of  Accounts 85 

Verifying  Accounts  Payable 164 

Verifying  the  Bank  Balance 56 

Voucher  Jacket,  the 163 

Voucher  Register,  the 163 

Voucher  System,  the 162,  165 

W 

Wages 171 

Warranties 92 

Water  Rates 172 

Watered  Stock 202 

Working  Back  the  Cash 56 

Working  Sheet,  the 215,  218,  219 

Writing  Down  Assets 151 


• 


UNIVERSITY  OF  CALIFORNIA  LIBRARY 

Los  Angeles 
is  DUE  on  the  last  date  stamped  below. 


24  1974 


Form  L9-32m-8,'57(.C8680s4)444 


Graduate  Sc^  01  of  Business  Administration 

University  of  California 
Log  Angeles  24,  California 


SOUTHERN    BRANCH 

UNIVERSITY  OF  CALIFORNIA 
LIBRARY 

LOS   ANGELES,  CALIF. 


